Consideration of Interest and Inflation in the Reserve Study

 

The two questions that continually arise are “Should interest and inflation be included in the reserve study; don’t they cancel each other out?” and “How do you calculate what interest or inflation rate to use?”

I believe that both inflation and interest earnings should generally be considered in the funding plan of a reserve study.  To ignore these would be to ignore reality. While it is a policy matter of the board of directors whether or not to include these items, it is common practice to include both interest earnings and inflation in the funding plan of the reserve study.  Inflation should never be ignored.  Failure to consider inflation will generally lead to significant future underfunding, unless the association updates its reserve study and underlying cost assumptions annually.

The fact is that interest earnings do not offset inflation.  While interest and inflation rates may be similar, the inflation factor is applied to the total estimated future expenditures for all common area components included in the funding plan.  This is (virtually) always a higher number than the current funds set aside for reserves.  Conversely, the funds set aside for reserves are (virtually) always a smaller amount.  That means that the dollar amount of interest earnings will grow far slower than the dollar amount of inflated costs, even if the rates are the same. An example is that an association may anticipate spending $3,000,000 over the next 30 years, which includes inflation calculations.  The current reserve cash on hand may be as little as a few hundred thousand dollars, as that is all that is required to pay for planned expenditures arising in the next few years.  Inflation of 2% on $3,000,000 is $60,000 annually.  An interest rate of 2% on $500,000 of cash invested generates only $10,000 of interest earnings annually, creating an annual funding gap of $50,000.

The second question, how do you calculate these rates, has no correct answer.  Some people use a rule of thumb.  Others look at their current interest earnings rates as a guide.  Current interest earnings rates cannot be ignored, but if they unusually high or low, it is not practical to expect those rates to continue indefinitely. However, so long as you keep your assumed interest earnings rate relatively the same as your inflation assumption, you shouldn’t get into too much trouble, as they do usually move in tandem.  California associations should be aware that California law limits the interest rate assumptions that may be used in a reserve study to 2% above the discount rate published by the San Francisco Federal Reserve Bank.

Since the funding “window” of a reserve study is normally a 30-year projection, many believe it is legitimate to consider average rates rather than current rates in establishing your funding plan.  The attached historical tables of interest and inflation rates allow you to put current rates into perspective.  Table 1 reflects solely at annual rates.  Table 2 reflects the 5-year average rate in any given year.   Table 3 reflects the 30-year average rate in any given year.  You will note that Table 3 does not contain the sharp peaks and valleys of the annual rates in Table 1.  However, general trends are still similar.

Note that regardless of sometimes significant annual variations in rates, the moving 5 and 30-year averages smooth out the rates considerably, eliminating the extreme spies and valleys that generally occur for only short periods of time.  Since the reserve funding plan typically projects for a 30-year period, it is usually safe to ignore current extreme changes in rates in favor of longer term moving averages.

I was forced to address this issue when I first started preparing reserve studies in 1982.  Look at the annual rates for that year and you can understand why.  If we had used the current interest and inflation rates of that year, NO reserve study could be developed that would provide adequate funding without “breaking the bank” by forcing reserve assessments so high that no one could pay them.  We opted then for using approximately 5% interest and inflation rates, because we knew the current situation was abnormal and could not be sustained.  Time proved us right on that assumption, but the fact is no one could reliably predict future rates.

Current interest rates are at an all time historical low.  Despite political pressure to keep rates low, they are beginning to trend back up.  Inflation rates reported by the government are also at all time lows, actually reflecting a deflationary rate in 2009.  However, because of changes made in recent years to the government data as to what is included in their calculations of the official inflation rate, current inflation rates are not comparable to prior data.

 Table 1

Table 2

Table 3