Inflation assumptions
The number your reserve study never explains, and why it matters more than the interest rate does.
A reserve study's funding plan rests on two assumptions: a long-term interest rate and a long-term inflation rate. Inflation raises the future cost of every component the association will eventually replace, while interest only grows the dollars already in the account, so the inflation assumption drives the funding plan far more than the interest assumption does.
Two numbers behind every contribution figure
Every reserve study's financial analysis rests on stated assumptions, not just the current balance. The preparer picks a long-term interest rate for money sitting in the account and a long-term inflation rate for the components the association has not replaced yet. Both feed the recommended contribution the board eventually puts in the budget.
A study that does not say what rates it used cannot be checked by the board that relies on it. Reserve disclosure practice calls for both assumptions to appear in the report itself, next to the funding recommendation they produced.
Why inflation moves the needle more
The two assumptions do not pull equally. Interest only compounds on the dollars already in the reserve account. Inflation raises the projected replacement cost of every component the association still has to pay for, roof, pavement, elevators, whatever is on the component inventory. Because most of the money a study is planning for has not been collected yet, the inflation assumption ends up doing most of the work.
"Inflation has a much greater impact on the funding plan" than the interest rate assumption does.
Source: What's Included in a Reserve Study? Key Elements Explained, Reserve Advisors
Change the inflation assumption and every future replacement cost in the study shifts with it, which is why two studies of the same property can recommend very different contribution amounts.
What to ask before you accept the number
No statute in this evidence base sets an inflation rate a reserve study must use. The rate itself, and whether a preparer explains why they chose it, varies by preparer and by current market conditions. Your job as a board is not to pick a number yourself, it is to make sure the study discloses the rate and can defend it.
If your report states a contribution figure without naming the interest and inflation rates behind it, ask the preparer for both before you put the number in a budget. A board that cannot explain its own funding plan's assumptions is not in a strong position if that plan is ever questioned.
Check yourself
Answer before you read the explanation, recalling it is what makes it stick.
Your reserve study assumes a 3 percent inflation rate for future replacement costs. A board member argues the interest rate assumption matters just as much. What's the accurate response?
A reserve preparer hands your board a funding plan but the report never states what inflation rate it used. What should the board do?
Two otherwise identical reserve studies use different inflation rates and produce very different recommended contributions. What explains the gap?
Sources
- National Reserve Study Standards (overview), Community Associations Institute
- What's Included in a Reserve Study? Key Elements Explained, Reserve Advisors
Reserves
Next, see how the interest rate assumption plays its smaller, but still real, role in the funding plan.
The specific inflation rate a preparer assumes, and whether the report explains and justifies that choice, varies by preparer and by current market conditions.