The scope & schedule of an Association’s reserve expenses are defined in the Reserve Study’s Component List. But once the Component List has been established, should the Reserve contributions necessary to fund those expenses be calculated using the “Straight Line” or “Cash Flow” method?
Reserve Funding Terminology & Similarities
In National Reserve Study Standard (NRSS) terminology, a distinction is made between the “Component Method” and the “Cash Flow Method” of funding plan computations. To clarify, the Component Method is commonly referred to as “Straight Line” while the Cash Flow Method is sometimes called the “Pooled” Method.
Both computational methods are similar in that they can incorporate estimates for interest and inflation. Both become out of date if not updated regularly. Both will provide poor guidance if the Reserve Component List is inaccurate.
Plans created by both methods can be undermined by Boards who don’t fund reserves at the recommended rate, spend Reserves carelessly, or (in some states) by owners who don’t vote to fund Reserves. Even though similar in many ways, these two computational methods are also very different. So, which reserve funding method is most favorable for your Association?
This issue is significant, because in at least one state (Florida), the owners must be made aware of their Reserve calculation method. No matter where your Association is located, it is wise to make an informed decision on the reserve calculation method and stick with it throughout your reserve planning process.
Straight Line Reserve Funding
In the Straight Line Reserve Funding (Component) Method, Reserve contributions for each component are calculated separately, and summed together for an Association total. The Association’s Reserves are essentially divided into separate “funds” for each component, with no co-mingling.
Contributions for each component are calculated based on the difference between the estimated replacement cost and the amount currently on hand, divided by the number of years until that expense is projected to occur. Because each component needs to stand on its own, reserve contributions calculated using the Straight Line Method can only pursue the most conservative “Full Funding” Reserve Funding Objective.
Cash Flow Reserve Funding
In the Cash Flow Method, the Reserve Fund is considered one large pool of money, where a steady contribution rate is established to offset the scheduled Reserve expenses from the fund (no matter what project those expenses are designated for… roofing, painting, pool resurfacing, etc.). Contributions are established by testing and retesting different contribution rates until the desired Funding Objective is achieved.
Which Method is Best?
Contributions for funding plans calculated with the Cash Flow method typically have the benefit of being lower. But with exactly the same set of repair & replacement expenses, how can this be? There are three reasons:
- Remember, Straight Line calculations can only be aimed at the highest “Full Funding” Funding Objective. In contrast, Cash Flow calculations can be aimed at other, less conservative objectives.
- Contributions calculated with the Cash Flow method handle the scarce (i.e., cash) resource more efficiently, allowing it to be used wherever and whenever it is needed. This is the result of the cash not being tucked away in restricted pockets for use with a particular component at a particular time. So, in the Cash Flow method, the average Reserve balance can be lower, while accommodating the exact same scope & schedule of expenses.
- Even when Straight Line and Cash Flow-based calculations pursue the same “Full Funding” objective, the Cash Flow method will still result in a lower contribution rate. This is because funding plans calculated with the Component Method tend to be front-loaded, meaning that the rate of contributions are temporarily higher in the first few years, then drop off in subsequent years.
The Bottom Line on Reserve Funding
The Cash Flow method typically results in a lower rate of reserve funding contributions. This is because the Reserve Funds can be used more efficiently, and the contributions are more evenly spread over the owners, over the years. So when a Board is confronted with a choice of computational methods, our professional recommendation is to choose the “Cash Flow” calculation method with a “Full Funding” objective as the best option.