Published in the ECHO Journal, July 2013
Board members of HOA’s may be finally sighing relief now that the housing crisis seems to be abating. However, the recovery of the housing market may be both a curse and blessing for HOA’s. No doubt homeowners are relieved to see their property values increasing but with that is also a rise in construction related activities and expenses. The ticking time bomb is the two-fold punch of thirty years of declining interest rates (now near 0%) and rising inflation of construction related costs. The result is HOA reserve unfunded liabilities are growing with no evidence that either interest rate will begin to rise or inflation will decline.
Like many crises, it is the process of years of erosion that in small increments are seemingly inconsequential. Until some point is reached that the issue requires significant attention and/or is potentially unresolvable. The issue regarding HOA reserve accounts seems to be on this glide path. For decades many HOA boards have elected to deposit all their reserve funds in bank savings or Certificate of Deposits (CD’s). It is not unusual for CCR’s to have the “FDIC” provision that requires all assets in the reserve account to be deposited into bank insured accounts. This seems reasonable for board members, who are both volunteers and fiduciaries, to be risk adverse. During the late 1970’s and through 1980’s interest rates issued by banks were at historic high levels with the Prime Lending rate peaking on December 19, 1980 at 21.5% that allowed many HOA reserve accounts to earn double digit risk-free rates.
However, since interest rates peaked they have steadily declined challenging reserve studies to determine a reasonable long term interest rate forecast. Every year as interest rates declined the unfunded liability would increase as interest earnings on the reserve accounts declined. It would seem inconceivable for a reserve study issued in the 1980’s to forecast interest rates declining for the next 30 years to 0%. But that is exactly what has happened. As a result, HOA’s financial vulnerability may be at the highest risk in decades as their unfunded liability may continue to increase should inflation start to accelerate and interest yields remain low. Every year that inflation outpaces interest earnings (net after tax) the risk of not bridging the gap of unfunded liabilities increases that will challenge HOA’s years later on either increasing member’s dues or compromising future projects. As mentioned earlier, a crisis develops slowly over time until it is too late.
HOA’s can learn from past experiences and mistakes of large pension plans that also faced the same challenge of underfunding. For decades pensions plans achieved their target returns and target actuarial year-end plan balance forecasts. However, in the early 1990’s, plans began seeing their unfunded liability widen as a greater number of participants were retiring than the addition of new participants. By the late 1990’s the deficit of outflows to retirees versus the inflow of employer contributions for new participant salaries was so great that many major companies feared their ability to meet their liabilities. To address the underfunding issue, many boards in the 1990’s decided to expand their investment policy to include more aggressive and risky investments in hopes of increasing portfolio returns and narrow the unfunded gap. In portfolio manager terms, many changed the expanded investment policy to increase the portfolio’s correlation to the S&P 500. In other words, the closer a portfolio is correlating to S&P 500 the closer the portfolio’s returns match that of the S&P 500. During the 1990’s this strategy proved productive as the US stock market performed well and banks were still offering mid-single digit interest rates on their fixed savings accounts. However, as you can guess the expanded investment policies exposed the portfolios to higher risk and a higher correlation to the stock market which meant that if the stock market declined the higher correlating portfolios may also decline. The 2000 -2003 “tech bubble” crash caused significant damage to pension plan assets forcing several high profile pensions into Federal receivership (United Airlines 2005). Even though pensions’ assets benefited during the 2003 – 2007 recovery, interest rates steadily declined reducing the yields on the short term fixed accounts. When the US stock market crashed in 2008 it was for many pension plans a fatal blow that forced many more plans and their companies into bankruptcy (Hostess 2012). Currently, of the 338 500 S&P companies with defined-benefit pension plans only 18 are fully funded. Seven companies reported that their plans were underfunded by more than $10 billion with the largest negative figure of $21.6 billion reported by General Electric (1)).
For many years I was the financial advisor for a mid-size Teamsters supplemental retirement plan who’s Investment Policy only allowed deposits into bank savings accounts or Guaranteed Interest Contracts (GIC’s are issued by large insurance companies with guarantees on principal with fixed period interest rates). Every six months I was instructed to obtain bids for a new GIC reinvesting the proceeds from a maturing GIC (similar to a CD laddered portfolio). At the end of each fiscal year the reported unfunded liability had increased as the interest earnings on pension assets declined with interest rates. During the early 2000’s the yield decline was minimal from 7.5% to 7.25% but after 2000- 2003 market crash yields dropped as the Federal Reserved lowered their interest rates 16 times in 24 months and after 2008 underwriters of GIC contracts had significantly lowered renewing GIC yields to below 3% with many insurance companies ceasing to offer new contracts indefinitely. To offset lowered annual earnings the board approved assessing more fees to the employers and participants but that did not cover the widening liability. Finally, in 2012 the board approved transferring the plan assets and liabilities to a larger Teamster’s retirement plan that was structured as a 401(k) plan.
What can HOA board members learn from the pension experience?
First, take the proactive approach of defining the annual growth rate of the reserve account to meet your goals versus adjusting the goals per rate declarations by financial institutions. Since 1980 the Consumer & Producer Price Index (CPPI) has an average annualized compounded rate of 2.96% per year (2). If the association pays a 20% tax rate then the benchmark target returns to match the CPPI net before tax should be around 3.70%. However, the CPPI may not be the appropriate inflation index as the purpose of the reserve account is to fund construction related expenses that do not necessarily inflate at the same pace as the CPPI. For the past several years, petroleum and metal costs have soared in price outpacing the CPPI by a wide margin that has impacted the costs of many construction products that include wiring, lumber, plastic piping, adhesives, paint, solvents, etc. Board members may consider whether the CPPI is a relevant target benchmark for the reserve account if construction related costs and services continue to outpace the CPPI.
Second, establish an Investment Policy Statement (IPS) that will allow the opportunity for the reserve account to achieve the target benchmark return. I have reviewed many IPS documents for both HOA’s and Pension plans that by design guarantee failure. For example, in “Goals and Objectives” section of many HOA Investment Policy Statements are the following investment parameters for the reserve account:
- Promote and assure the preservation of the reserve fund’s principal
- Assure availability of funds in the reserve account to meet anticipated liabilities
- Minimize the effects of interest rate volatility
- Achieve long-term return on reserve fund assets that exceed inflation by 1% – 3% on net after tax basis
These Goals and Objectives assure the HOA board members of years of frustration and challenges. The first parameter is in itself confusing and rarely explained. Is “preservation of the reserve fund’s principal” the simplistic definition of not losing the actual principal or the more accurate definition of losing principal purchasing value and the inability to fulfill the purpose of the reserve account? What difference is there from the inability to purchase an item due to loss of principal or the inability to purchase an asset because the item has increased in price? Either way, the HOA cannot achieve the stated goals of the reserve account and alternatives will need to be considered such as raising member dues or postponing construction projects. In addition, this first parameter conflicts with the fourth parameter paralyzing board members to use fixed rate guarantee accounts (e.g. Certificate of Deposits) to outperform by 1% – 3% a variable increasing index. My research on yields for short and intermediate maturity interest accounts with principal guarantees have rarely if ever produced a yield that exceeds the CPPI inflation by 1% – 3% before tax. Today, the failure of these Goals and Objectives is very evident in which HOA board members should be earning 4.7% – 7.7% on their reserve account (based on the 32 year CPPI average and a 20% tax rate) while saving account yields hover around 0%. The third parameter further challenges the board members to “minimize the effects of interest rate volatility” by possibly purchasing longer maturity deposit accounts (e.g. three years or more) during declining interest rate periods (a possible conflict with the second parameter) and shorter maturity during rising interest rate periods. Not addressed is how volunteer board members meeting four times a year that are not typically trained on domestic and international currency markets that influence interest rates will define the complexity of interest rate trends and select appropriate maturity durations. For years many board members have missed locking in higher yields on longer term CD’s in anticipation of rising interest rates that have continued to decline. Now with rates near 0% board members are concerned about committing funds into longer term CD’s while the return in the reserve account suffers.
Financial institutions typically deposit their low risk funds in fixed income portfolios that by design earn well above their own issued bank savings rates. To state the obvious, banks reinvest HOA deposits into fixed income portfolios to earn a profit spread. Why doesn’t the HOA allocate some or the entire portfolio in a similar fixed income portfolio instead of letting the banks earn the profit? Banks and insurance companies have built multi-trillion dollar organizations principally on the spread between yields they pay to depositors versus the return on their fixed income portfolios. I have heard HOA conference speakers say that depositing reserve funds in anything other than FIDC savings accounts is exposing the HOA to unwarranted risks and potential 50% account declines. Jumping from a strategy of using guaranteed deposit instruments to investments that can decline 50% is both irresponsible and inappropriate.
If the Investment Policy is limiting the ability for the HOA to achieve the goals for the reserve account then the obvious solution is to amend the Investment Policy. The CCR’s of many HOA’s established after 2000 require the reserve funds to be deposited into FDIC insured or bank issued savings accounts. This year many HOA’s are going through the arduous and expensive process of re-stating their CCR documents to meet Davis-Stirling compliance. This is an opportunity for board members to cost efficiently expand the parameters of the Investment Policy that will allow HOA board members to have more options to consider for their reserve account (including guaranteed deposit accounts) to potentially achieving its target return.
Don’t wait until it’s too late. Trustees of pension plans procrastinated as the unfunded liability widened and then took overly aggressive steps with their investments in hopes to narrow the gaps. One key difference between pension plans and HOA’s is pension plans have the back-up of the Pension Guarantee Benefit Trust, a US government agency. HOA’s do not have any such government agency to fall back on if they cannot meet their unfunded liability.
- Source: U.S. Dept. of Labor, Bureau of Labor Statistics. Prepared by the Capital District Regional Planning Commission.
- New York edition, July 21, 2012, page B3 article titled, “Private Pension Plans, Even at Big Companies, May be Underfunded”
Anton Bayer will be speaking on this topic at the August 24, 2013 ECHO San Jose Conference. Mr. Bayer is the CEO of Up Capital Management, a Registered Investment Advisory firm, and has over 30 years’ experience as a Registered Investment Advisor and/or Registered Representative. Sign up for his newsletter or contact him at his website www.upcapitalmgmt.com.