Reserve Funds 101
There has been much ado about reserve studies, reserve funds and investment of reserves in the last few years, fueled largely by changes in Colorado law related to reserves. It is no wonder board members and managers often have a lot of questions about what is required and what is prudent. This article is designed to set forth the facts about reserves in relation to requirements and best practices.
What are Reserves?
“Reserves” are funds an association sets aside to cover the anticipated costs for the replacement of or significant repairs to major common area components that the association is obligated to maintain. Reserve expenses are those expenses incurred by an association for such replacement or repairs. Reserves are typically not for regular maintenance. For example, regular maintenance of fences, such as replacing broken slats, is not a reserve expense. However, a complete replacement of a fence at the end of its useful life would be.
Does an Association Have to Have a Reserve Study?
Under Colorado law, no. Associations are not required to have a reserve study. However, associations must have a policy that addresses when a reserve study is going to be done, whether the study is based on a physical and financial analysis and whether there is a funding plan for the work recommended by the study. Colorado law, as you can see, does not go as far as requiring associations to have a reserve study or to fund it at any particular level.
So, What Should an Association Do?
Having a reserve study policy, as required by law, is a must. But the question then arises whether associations should have a reserve study, even though not required, and at what level the reserves should be funded.
For any association that has components in the community it is obligated to repair and replace, best practices would indicate having a reserve study completed, whether it is completed by a reserve specialist or another qualified individual. That study should include at least:
- A listing of the components to be maintained, including their quality, useful life, remaining useful life, and current replacement cost.
- A projection of the of the reserve fund starting balance, reserve contributions needed, expected reserve expenses, and the estimated ending reserve fund balance going out at least 20 years.
Then, an association must establish a reasonable funding plan to ensure there is enough money in the bank to cover reserve expenses as they arise. There are four funding models most associations utilize, which are:
- Full funding, with a goal to maintain the reserve fund at or near 100% of what is required by the reserve study at any given time.
- Baseline funding, with a goal to keep the reserve fund above zero at all times.
- Threshold funding, with a goal to keep a minimum, predetermined amount in the reserve fund at all times.
- Statutory funding, which is based on local statutes.
How Does an Association Invest its Reserve Funds?
Colorado law requires associations to have an investment policy which discusses investment policy. Regardless, in making any investment decisions, boards must follow the prudent investor rule. The prudent investor rule provides that members of a board shall exercise ordinary care under the facts and circumstances prevailing at the time of the decision. In doing so, boards should consider the long-range and short-range needs of the association, the association’s present and anticipated financial requirements, the expected return on investments, price level trends and general economic conditions. Further, boards must invest and manage the association’s funds as a prudent investor would, taking into consideration the purposes, terms, expenses and other circumstances of the association.
The bottom line is that boards must take a hard look at reserves, and make informed and prudent decisions in the best interest of the entire community.