Amid Inflation, It’s Time to Review Reserve Policies
While it’s easy to see how rising prices are affecting association budgets, it’s not as obvious how inflation and economic uncertainty may impact reserves. Experts advise reviewing policies to ensure operating reserves are poised for inflation and long-term reserves will sustain you moving forward.
Inflation is affecting many aspects of association finance—including, surprisingly, reserves. Overlooking that impact would be a mistake, say experts at Raffa Investment Advisers.
“Inflation is absolutely impacting association reserves and reserve policies,” said Dennis Gogarty, president and cofounder of RIA. “If, for example, an association is holding more of their reserves in cash or other short-term investments than they will spend in the near term, then these assets are losing purchasing power to inflation. The current environment should be a wakeup call and drive a review of policies.”
After all, reviewing reserve policies helps ensure the association’s assets are best-positioned to withstand both current and future economic conditions. One thing to consider when reviewing policies is asset segmentation. RIA’s Study on Nonprofit Investing research shows that most organizations organize their assets into three buckets: an operating (cash) reserve, short-term investments, and long-term investments. Here’s a look at how to keep these buckets in mind as you review policies.
Review Operating Reserves
Figuring out how much the organization will need in the operating reserve is crucial when dealing with inflation. When reviewing their reserve segmentation and current expenses, associations should ask themselves some key questions.
“How did you land on how much to hold in an operating, short-term, or long-term reserve?” Gogarty said. “What are the risks and opportunities your organization faces in the near, short-, and long-term? How has the financial condition of your association changed over the past few years—and does that affect your ability to take risk with your investments? Yes, your cash assets may be losing out to inflation, but you may be able to increase revenue or cut expenses more easily than you’re able to chase 8-plus percent returns in the market over a short time period.”
If an association hasn’t reviewed its policies lately, it’s not too late to get started.
“Inflation is likely to remain elevated for the foreseeable future,” said Ryan Frydenlund, RIA senior operations manager. “So, it’s not like associations have missed the boat on having these conversations. It’s still prudent to sit down and review not only your reserves segmentation, but also the balance of each of those buckets.”
Such reviews typically can be completed in two to four weeks.
Rebalance to Meet Investment Allocations
When reviewing asset allocation, organizations should make sure their investments align with their stated investment policies. For example, most policies have an investment allocation—perhaps 50 percent stock, 40 percent bonds, and 10 percent cash. However, because stocks have performed so well recently, investments may be too heavily tilted toward stock. Rebalance to ensure the portfolio hasn’t drifted too far from the allocations and make sure the reserve buckets are allocated properly.
“If they haven’t realigned those buckets, then they may have too much money in long-term investments that they could need if their expenses rise as a result of inflation, and they’re not able to increase their revenue commensurately,” Gogarty said. “They may need to take from reserves.”
Ensure Reserves Are Ready for Another Rainy Day
In addition to inflation, there is talk of a possible recession coming. For associations that had to dip deeply into their reserves in 2020, their accounts aren’t ready for another hit.
“If your association had to spend down reserves, as many did in 2020, you should first look at ways to build back up the protection a reserve fund provides,” Gogarty said. “We recommend looking to budget for a contribution to reserves or look to use at least a portion of net operating income to add back to reserves.”
Mark Murphy, RIA chief investment officer, agreed, adding that rebuilding reserves is a longer-term solution that should be coupled with other strategies.
“It’s not something that just gets fixed overnight,” he said. “It’s a combination of trying to add more into your reserves, but then also trying to take action in the current time and seeing where you could trim expenses and grow revenue. This is all in the attempt to try and build up that investment reserve cushion.”
In addition to building up reserves, consider reviewing the association’s past performance to offer insights.
“It could be helpful to look back to operations during the [last] financial crisis to see how the organization performed,” Gogarty said. “Did the organization need to dip into reserves at that time? If so, how much? Also, consider if your organization is in a different operating position compared to that time and adjust accordingly.”
How is your association reassessing its reserves to deal with inflation and economic uncertainty? Share in the comments.
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