Investing the Reserve Fund Minimize Risk and Maximize Yield

Investing the Reserve Fund

If you were walking down the street and spotted a $100 bill on the ground, would you stop and pick it up? Of course you would,

and in the literal sense you could consider this $100 found money. Surprisingly, every day, many members of co-op boards and condo associations are unknowingly choosing to ignore thousands of dollars in found money that could be retained in their buildings' coffers for the benefit of their shareholders. All too often boards do not make optimal use of their reserve funds. And to make matters worse, due to common misconceptions their reserve funds may not be adequately insured.

However, with proper planning, these pitfalls can be avoided, and the reserve fund can be managed to minimize risk and maximize yield. When making investment decisions, the board must keep three key concepts in focus: security, investment yield and liquidity. Here's how to ensure these bases are covered.

What Type of Account?

Let's start with the most basic building block of the investment process: the account itself. Banks and thrifts offer insured accounts, money markets and appropriate investment products; however, they are limited in that they do not usually offer these services bundled within one account and they are further constrained because they offer only up to $l00,000 in Federal Deposit Insurance Corporation (FDIC) insurance. Another factor to keep in mind is that with a bank account you can't assume that idle cash is automatically invested in an interest-bearing account.

One of the most efficient methods of managing cash is through a cash management account which is available at several securities firms and can offer an automatic sweep of idle cash into a high-yielding money account. This service, which is not usually offered by banking institutions, is particularly important to co-op boards because the reserves can earn interest at all timeseven when waiting for a decision by a co-op board regarding the investment of funds. These accounts are insured by Security Investor Protection Corporation (SIPC) which provides protection for the first $100,000 in cash and the next $400,000 in securities against theft or loss. In addition, some firms provide insurance protection over and above these amounts.

A board could stop at this point and allow interest from the money market account to accrue and consider the funds fully invested. In fact, this is how many boards manage reserve funds. However, in my opinion this is a highly inefficient use of a building's funds. And to exacerbate the situation, funds are often invested in low-yielding bank money market accounts that are only insured up to the $100,000 FDIC limit.

Stocks, Bonds and Securities

Other investment options exist that both increase the insurance protection on the loss of principal and offer higher yields. Fixed income investments are so named because at issuance the amount of interest, or coupon payment, is fixed for the life of the investment. The risk of these investments lies in the creditworthiness of the issuer and something called interested rate risk or sensitivity.

The least risky are those issued by the federal government, such as treasury securities, or the ones insured by the FDIC, such as certificates of deposit (CDs). Somewhat riskier investments include investment grade bonds issued by major corporat ffb ions like General Motors or General Electric. And riskier yet are debt securities issued by lesser rated or unrated corporations, sometimes called junk bonds.

Stocks, also known as equities, can be excellent investments for individuals or institutions with long-term investment horizons. Over long periods of time portfolios comprised of equities have outperformed bonds; however, stocks may not be appropriate for co-ops because their performance cannot be guaranteed, particularly for shorter, finite periods of time.

Mutual funds, another investment option, are professionally managed portfolios of stocks and/or bonds. Like stocks, these can be appropriate investment vehicles for individuals with long-term investment horizons. But, since returns from mutual funds cannot be guaranteed, they may not be appropriate for co-ops.

Building an Investment Portfolio

When building an investment portfolio of fixed income investments you first need to ask two basic questions. Are any capital projects planned? And what, if any, are the plans for the balance of the funds? Unless a specific project is planned, many buildings maintain reserve funds for unknown, unforeseen contingencies and it's often years before these funds are required for any use. In many cases, from a board's perspective, the existence of the reserve fund is more cosmetic in nature and is established using informal rules of thumb with an eye toward trying to address the concern of potential buyers of apartment units.

The American Institute of Certified Public Accountants (AICPA) is far more specific and more concerned with the structural integrity of the building when giving its members guidance with respect to the traditional accountant's report letter that appears as the first page of a co-op's annual report. The problem that arises when complying with the AICPA directive is that it requires a co-op to have a formal engineering study completed by an outside consultant in order to establish an adequate level of reserves to maintain building systems. The magnitude of the level of reserves required to comply with an engineering study can be eye popping to board members.

For example, let's assume that ABC Owners Corp. has established a reserve fund of $250,000, but they are planning to have a new roof installed for $50,000 that requires two equal payments, one in four months and the last in eight months. The board has no plans for the balance of the funds of $200,000, and the board feels comfortable with maturities on its fund income investments of up to two years for some portion of these funds. How should this board invest its reserve fund?

First, we would invest the funds earmarked for specific capital projects, in this case a new roof. To satisfy this objective we would buy two CDs in equal amounts timed to mature when the required payments are due to the roofing contractors: based on our example, one $25,000 CD due to mature in four months, and one $25,000 CD due to mature in eight months.

Next we would allocate the balance of the $200,000 into four CDs in equal amounts of $50,000. We then build a ladder of CDs, i.e. a staggered portfolio of CDs going forward two years, with one $50,000 CD maturing in six months, another maturing in one year, a third maturing in 18 months and a fourth maturing in two years. At the end of six monthsassuming there's no need for the funds at the time of maturity and that there is no planned capital projectwe would simply reinvest those funds out another two years, thus maintaining the two year ladder. As a result, our portfolio would always have 25 percent of our reserve funds due six months in the future, thereby dealing with the issue of liquidity.

In a rising interest rate environment, laddering the portfolio allows the board to take advantage of rolling CDs into investments with higher yields. In a market where interest rates are dropping, by locking in rates the board can be confident that they are outpacing shorter term investment options while not exposing the board to unwarranted interest r e7f ate risk.

When selecting CDs, board members should keep in mind that if the CDs are purchased from banks or thrifts there is a limitation of $100,000 of FDIC coverage. As an alternative, several securities firms make available CDs that are issued by a variety of banks throughout the United States. Since the depositor is insured for $100,000 per institution, purchasing CDs issued by different institutions can maximize federal deposit insurance protection.

For example, Merrill Lynch, the largest broker of CDs, could effectively provide one investor with CDs from several different banks, therefore keeping your funds fully insured. In addition, CDs made available by securities firms often carry higher interest rates than those purchased directly at the bank. In effect, by purchasing CDs through a brokerage firm, a board may be able to obtain higher rates and maximum FDIC insurance protection thereby providing one-stop shopping.

Special Tax Considerations

Co-ops with special tax considerations, such as those concerned with 80/20 issues, should consider investing in investment grade, insured municipal bonds and tax free money market funds. Basically, for co-ops with tax concerns, the investment process described above for taxable investment securities would apply when using tax exempt instruments; however, co-op boards should consult their tax advisers for further information.

Mr. Kokalari, a financial consultant with Merrill Lynch & Co. in Manhattan, specializes in co-op finance and investment management. He has served as both president and treasurer of his own Manhattan co-op.

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