“Does Interest Offset Inflation?”

By Robert M. Nordlund, P.E., R.S.

Interest and inflation are economic realities in our world today. We all expect to earn interest on our savings and investments, and things cost more now than when we were younger due to inflation. So interest and inflation exist now, and it can be reasonably assumed that they will exist for the foreseeable future. But is it appropriate to consider interest and inflation in a Reserve Study?

A Reserve Study is based on estimates and projections. The better the estimates and projections, the more accurate the Reserve Study. If I project 3% inflation for the next ten years, and then 10 years from now find that over that time span the inflation had averaged 4%, I might not have sufficient Reserves to perform that Reserve project. Even so, I would certainly be closer than if I had assumed no inflation!

Typically, people tend to believe the two factors tend to offset each other. Interest earnings increase your bank balance, helping you to have more money to keep up with rising costs due to inflation. But here’s the key: interest earnings only apply to the funds you actually have on-deposit in the bank. Inflation works its effect on the “basis”, the entire magnitude of the anticipated expenditure. Therefore it is always a losing game of catch-up. Consider the example of a $10,000 pool with a 10 year Useful Life between resurface projects. If half the pool’s life is used up and you have half of the replacement cost in the bank (“Fully Funded”), you are earning interest on $5000 but inflation is working on the entire $10,000 resurface cost. With 3% inflation the resurface cost goes up by $300 per year, yet with 3% interest you only earned earn $150. You just lost ground by $150! This problem is compounded since most associations are underfunded (less than the Fully Funded amount of Reserves on-deposit). Thus in the above example they would have even less than the desired $5000 in the bank earning interest!

So while interest earnings compensate for some inflation effects, interest earnings do not offset inflation losses. Updating your Reserve Study annually and including interest and inflation assumptions are your best defense against letting these differences grow to a level that causes a special assessment.

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