By Nicole Bailey, RBC Wealth Management
The funds collected and managed by community associations are designated to be used for the benefit of the association. Association governing documents require some part of the annual assessments to be set aside for the future repair and replacement of community assets. As these reserve funds accumulate, it’s important to ensure the funds are available when they are needed to pay for major repairs and asset replacements. The association’s reserve study provides a schedule of the reserve spending so that the association can build a plan to fund the reserve account sufficiently. The association can also work with a qualified financial advisor to structure an investment strategy that helps protect the funds and generates interest income to supplement the contributions to the account from the homeowners’ assessments.
The homeowners in the community have entrusted elected members, management, and other professionals to properly manage and maintain the association. Everyone who serves the association (homeowners, board members, managers, community experts, etc) is expected to act in the best interest of the association. When selecting a financial advisor for an association, the board and community manager should seek out an advisor who acts in the best interests of the association.
Once a qualified investment professional has been engaged, the board and the advisor can develop an investment strategy that helps protect the funds, verifies they are available as needed, and generates a reasonable return given the first two objectives are met. The association’s investment policy provides the general parameters that inform the strategy to be implemented by the advisor.
As part of the investment objective, the investment policy outlines the types of risk the association should avoid or attempt to mitigate. These risks often include credit risk, liquidity risk, and inflation risk. It is important to have an awareness and understanding of the other types of risk the funds could be exposed to even if they are invested in what are commonly considered “safe” investments.
All investments come with different types of risk, so it is important for the board to consider which types of risk are acceptable and which types are not. Below is a summary of the different types of risks involved with investing:
- Interest Rate Risk: Changes in interest rates which result in changes to the market value of the investment. (ie: Interest rates rise and the market value of bonds falls)
- Liquidity Risk: Investment cannot be converted to cash when the funds are needed without resulting in a loss of principal investment. (ie: Funds are in a CD that doesn’t mature for 6 more months)
- Credit Risk: The investment’s issuing entity is unable to fulfill its obligations. (ie: Bank failure)
- Inflation Risk: Prices of goods and services rise and the funds experience reduced purchasing power. (ie: Painting project costs $75,000 today and $80,000 2 years from now)
- Reinvestment Risk: The funds currently invested will be reinvested at a lower return in the future. (ie: Interest rates are expected to be lower in 6 months and the funds are maturing in 6 months)
In addition to the restrictions on risk, the association’s investment policy includes information about the investment strategy and the relationship between the board and the financial advisor. The policy should outline the goal of the investment strategy – why are the funds being invested? Is it to ensure the full amount of the funds are FDIC insured (beyond $250,000)? Is the association seeking to increase the amount of interest being earned? When identifying the investment timeline, the policy should reference the reserve study. If the reserve study calls for limited spending for the next 5 years, the investment policy should not limit the investment timeline to 2 years. In alignment with the discussion of risk, objective, and timeline, the policy can identify the types of investment vehicles to be used or avoided in the account. Many policies restrict investments to certificates of deposits or investments guaranteed by the federal government, which is in alignment with the mitigation of credit risk. Some policies allow for a percentage of the funds to be placed into diversified stock positions which is in alignment with the mitigation of inflation risk. These restrictions and allowances should be carefully considered and approved by the board of directors. The board’s expectations for the management and communication around the account should also be specifically outlined in the policy.
Under the fiduciary umbrella, the board of directors should partner with a qualified financial professional and adopt a comprehensive investment policy. By leaning on professionals and policies, the community may reap the benefits of long-term growth in the account in order to meet the future needs of the association.
Nicole Bailey, CFP ®, Vice President - Financial Advisor
RBC Wealth Management, a division of RBC Capital Markets, LLC, registered investment adviser and Member NYSE/FINRA/SIPC.
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