Deciding between "Cash Flow" and "Percent Funding" your Reserves

By: Robert M. Nordlund, P.E., R.S.
January, 2004

Hawaii law (Section 514A-83.6) requires each association to update their Reserve computations each year as part of their annual budget, and include a specific statement about whether the amount of Reserves the association will be collecting was developed using "a percent Funded or cash flow plan". What is this choice, and what does it mean?

Hawaii law is the only state (as of this writing) that requires compliance with respect to funding Reserves. An association needs to choose, in National Reserve Study Standard terminology, between two objectives:

• Baseline Funding: where the association's objective is to have sufficient Reserve income "cash flow" over at least the next 20 years to not need a special assessment or loan, or
• Threshold Funding: keeping the Reserve Fund at or above a specific cash or Percent Funded (minimum of 50% Funded in this case) status.

Baseline Funding allows an association's Reserve Fund to theoretically drop to $.01, never becoming completely depleted. When an association is Baseline Funding their Reserves, the Reserve Balance is lower, on average, than with other more conservative funding objectives. On one hand, this means more money is in the bank accounts of the owners and less in the bank account of the association. On the other hand, the association is at more risk of a special assessment because the association has no "margin for error". Note also that the association's income from outside sources is lower due to lower interest earnings on the Reserve fund.

Funding Reserves at or above the 50% Funded point means that not only does the Reserve Fund need to stay above $.01 without reliance on special assessments or loans, it must stay at or above 50% of the deteriorated portion of the common areas planned for replacement. This is a figure that changes each year, and needs to be re-computed each year. For instance, if the life of the $400,000 roof is one quarter used up this year, the deteriorated portion this year is $100,000. If the association's current total of common area deterioration is $250,000, being at least 50% Funded means the association has at least $125,000 in the Reserve fund. Being at least 50% Funded does not mean the association has on hand at least 50% of the total replacement value of the common area assets on hand. Being at least 50% Funded does not mean the association is making at least 50% of the Reserve contributions it is budgeted to make. Percent Funded is a comparison between the amount of cash in the Reserve Fund and the deterioration portion of the association's common area components.

In both cases, the association needs to identify its future common area expenses and make some financial projections. In both cases, the deterioration of the common area expenses continues independent of the funding method chosen. The association's Reserve expenses will be identical in both cases. The roof doesn't care if you are "cash flow" (Baseline Funding) or "percent funding" (50% Threshold Funding) the Reserves. The only difference is how much cash the association will have on hand in the Reserve fund, on average.

Associations choosing to Baseline Fund their Reserves obtain less interest from their financial institutions, and have a measurably higher incidence of special assessments due to less "margin" for the unexpected. Associations choosing Hawaii's "Percent Funded" method are choosing to have at least 50% of the value of common area deterioration in the Reserve Fund. There are measurably fewer special assessments and there is less deferred maintenance at these associations, and their Reserve interest checks from the bank are larger.

Remember, the association's expenses are identical. The only question is how much Reserves will be on-hand on an ongoing basis.


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