In a prior blog post I noted that fully funded means being on track to have saved enough to pay for the future cost of an expense. Break that down and there are some ambiguities involved that might be surprising. The "future cost of an expense" will always be an educated guess, but what about the "on track" part? If you're five years into a ten-year replacement cycle, how much of the future cost will be reflected in the fully funded figure?

If you assumed the answer is 50% you may be in for a surprise.

In practice, after reviewing studies produced by several professional organizations, I've never seen it computed that way. There's usually vague wording about full funding that suggests it might consist of equal amounts put aside each year leading up to a purchase. Instead, it's typically computed as proportional to the price in that year - ignoring inflation still to come. With this approach, each year the fully funded amount goes up not just in proportion to how close you are to a purchase, but also to make up for additional inflation that wasn't factored into prior years. These are anything but equal amounts as it amounts to chasing a moving target.

It's easiest to see this with a concrete example. Take an item worth $10,000 the last time you purchased it. Assuming a ten year replacement cycle and 3% inflation, in ten years it will cost about $13,440. Here are two savings plans - one with equal amounts put aside each year, and the other matching what is typically seen in reserve studies:

Both of these add up to $13,440 over ten years. One does so by adding equal amounts each year, the other by increasing the amount added at a rate varying from 6% to 5.43%, significantly faster than inflation, to make up for the moving target.

In year eleven things get interesting again. This is the first year of a new savings cycle for an expense of $18,061 due to ten more years of inflation. Here's what that first year looks like with these two schemes:

Look back at how this compares to year ten, and you'll see that the amount added to the fully funded figure jumps by more than 34% in one year for the equal amounts scenario, while in the typical reserve study it will acually decrease by more than 18% before starting back up again.

Do these discontinuities matter?

If your expenses from one year to the next were constant, the discontinuities might never be noticed because they'd average out. This is probably why it is still done this way, but ignoring the implications does have consequences:

• Relative to an idealized amount that tracks inflation, the moving target strategy underestimates the fully funded amount by more than 12% in the first year in this example and then begins to close the gap. The equal funding strategy overestimates by almost 15% before tracking back toward an accurate final figure.
• Capital expenses are almost never evenly distributed over time. Long-lived capital assets result in pricey projects like re-roofing a structure will have outsized impact, making the cycle of under- or over-estimation and correction much more obvious.

Worse yet, these two compound. With the moving target strategy, a roofing project in 30 years with 3% inflation will be underestimated by almost 32% initially! So the biggest discontinuity with the largest overall impact will be the least accurate. Ever wonder why you seem to be well-funded one year and then things start looking worse a few years later? Wonder no more.

Is there a better way?

That idealized figure referenced above? The one that neatly tracks inflation from one year to the next? Why not use that?

Frankly, I have no idea.

It's not all that hard to compute, and it really does just track inflation with no discontinuities at all between one purchase cycle and the next. This is Capital Plans' default strategy, dubbed "Inflation Ramp." Here's how it nestles between the others:

They're all viable strategies that wind up putting aside the same amount of money, but only one manages to do so with a steady, predictable funding cadence.

There's no substitute for up-to-date estimates. Reach out periodically for updated replacement quote for your longest-lived capital assets to ensure that they're as accurate as possible. Every time an expense is paid the corresponding estimate should also be updated. Keeping good records is essential for any capital expense forecasting exercise.

In attempting to forecast the future, however, even the most up-to-date quote has to be adjusted for inflation.

Keep in mind that the rate of increase for capital expenses isn't tied to consumer inflation indexes, which are based on a broader range of expenses than just capital costs. Your operating budget may track this more closely, but an inflation rate specific to construction costs may serve you better for capital projections.

Whatever rate they choose, a reserve study will compound inflation over time. This is typically done on an annual basis, where 3% inflation per year over a decade yields an increase of roughly 34.39%. Curiously, some reserve studies compound inflation monthly instead, possibly just using the same formula they use for calculating interest. Doing so would yield a 34.94% increase instead in this instance. Spot-checking a few figures may help you understand how your reserve professional chooses to forecast the future.

Interest is accrued over the course of a year based on assumptions about when contributions are added and expenses are removed from the account. Different reserve studies can make a wide variety of assumptions that may or may not be realistic. They typically assume that the interest rate specified is compounded monthly, which is reasonable, but we've reviewed more than one that assumes that contributions are added through the course of the year but that no expenses are incurred until December 31st. This is plainly absurd and results in overly optimistic interest projections. Capital Plan assumes that both income and expenses are evenly distributed through the year.

Taxes are typically due on interest earned, even for a non-profit organization like a condo association. Since the tax payment iself doesn't qualify as a capital expenses, it's often the case that they cannot be paid from reserves and must form part of the operating budget. Don't let reserve studies that suggest otherwise lead you astray! Capital Plan defaults to assuming a 0% tax rate to reflect the typical situation.

Lastly, be wary of overly optimistic rates of return. it's not at all unusual to keep some portion of capital reserves more liquid for short-term needs and to stagger investments. This results in varying yields across different portions of reserve savings, so the single rate used in a reserve study must anticipate an average rate of return. As a prediction of future returns you're never going to get this exactly right, so it's mostly about getting in the ballpark.

Positive reserves at year start and year end are not sufficient to guarantee that you won't run out of money. Costs are rarely paid out evenly through the course of the year, so in instances where the balance at the start of the year isn't sufficient to cover all anticipated costs it's important to do month-by-month breakdown. Capital Plan will highlight years when this may be necessary.