Is Percent Funded Based on Current or Future Costs?
A client recently asked a good question: if Reserves are all about becoming prepared for future expenses, why would you use current cost in computing the Percent Funded (Reserve Fund strength) value for the association?
It's a great question. As articulated in National Reserve Study Standards , Percent Funded calculations are based on current replacement costs, not future replacement costs. This is the case because the Percent Funded reports the current strength of the Reserve Fund, which is the comparison between the current "needs" of the association (the computed Fully Funded Balance) and the current Reserve balance. Percent Funded tells you "where you are now" with respect to Reserve Fund strength, so it is fundamentally based on current status issues.
Please note that any Funding Plan calculations, however, should consider interest and inflation, and thus should use "inflated" future costs. That is because the objective of the Funding Plan is to direct a steady cash flow stream towards a future expense target. The incoming cash flow is growing (just a little bit) with interest, and the expense is growing (a bunch more) with inflation. Those very real factors are necessary in order to craft an accurate Funding Plan that prepares the association for that future (inflated) expense. But Funding Plan calculations are very different than, and not tied to, Percent Funded calculations.
When we make calculations about Percent Funded in future years (in order to calculate the strength of the Reserve Fund in future years with a particular Funding Plan), we use a future cost for that particular future year. So if a component is projected to cost $10,000 this year and it is 5/10ths "used up", the Fully Funded Balance (and therefore the resulting Percent Funded calculation) is based on the association's needs which are $5000. But next year, with 3% inflation, that "current cost" will be $10,300. The asset's life will theoretically be 6/10ths "used up", so the Fully Funded Balance will be $6180.
Each year, no matter which year, the "current cost" of the expense that year is to be used in the Fully Funded Balance calculation (and resulting Percent Funded calculation) for that year.