Setting Up Your Reserves

Declining memberships, low conference attendance, and poor investment results have affected the finances of many associations, causing them to look more carefully at their reserves.

Are your reserves sufficient? To answer this question, you must first understand the different types of reserves.

1. Operating funds are composed of money collected but not yet spent within the current fiscal year (no longer than 12 months out). These reserves provide a higher yield than a checking account, but are available when money is needed.

2. Short-term reserves are funds held for possible annual shortfalls and invested for use within five years.

3. Long-term reserves have various purposes. They may back up an existing reserve or may be an endowment, foundation, scholarship, or building fund. The usual guideline is that the principal won’t be used for at least five years.

First steps

When setting up your reserves:

• Separate your organization’s reserves into pools of money based on the intended purpose for each fund. While specific names for these pools will vary, define the purpose for each and the time horizon for the money.

• Write an investment policy for each pool of money. Your investment policy should

  • be aligned with your organization’s mission,

  • blueprint the entire program, and

  • define the roles and responsibilities of board and staff.

It also should describe the activities expected of any consultant or money manager and detail your allowable investments and your investment goals.

• Match assets to liabilities. Reserves should be held so that their availability and price volatility match the time frame when they are needed. If a liability is due within five years, it should be matched with assets that mature within five years, or exhibit the volatility appropriate for a five-year time frame.

Reserves analysis

To analyze your reserves, you’ll need your organization’s total revenue, total expenses, and reported net income for the past 10 years. Shorter periods can be used, but five years is the absolute minimum. The following examples illustrate how an analysis might be conducted and other benefits such an examination can produce.

• Look at your financial history. Association BBB had $2 million in operating reserves and $3 million in long-term reserves, which is roughly equal to its annual revenue. This level of reserves is substantially greater than the typical association. ASAE’s Operating Ratio Report suggests that the typical association has about 40 percent of its revenue in reserves.

Revenue and expenses for BBB Association

Mean and volatility of revenue and expenses for BBB:

It was calculated that once in 10 years BBB might have a $1,695,188 loss and once in 20 years, a $2,299,262 loss. However, the actual loss in year seven was greater than the projected once in 20-year loss.

Staff and board members believed the year seven loss was unlikely to be repeated. Staff also thought the operating losses experienced by BBB were representative of future events and that the preceding 10 years were predictive of future net income. They expected smooth operations with a possible negative event in five or six years.

It was recommended that BBB move $1 million from the operating fund to short-term reserves, thus separating its funds into two distinct pools of money with separate purposes and investment objectives. The transition was conducted in a series of steps so that the operating fund was not affected if unforeseen events occurred during the changeover. BBB moved $1 million currently held in overnight securities to longer maturity certificates of deposit and treasuries. This generated an additional $10,000-$15,000 annually.

• Develop key ratios. Often, it is useful to create ratios for examining the adequacy of financial reserves. CCC is a trade association that had $15 million in revenue in 2002. The association pays itself 8 percent each year from its long-term funds to support ongoing operations.

  As a result of a member query about the asset allocation of CCC’s long-term reserves, the association reviewed its reserve practices and made two decisions:

  • To segregate investment income from operating income. Because 8 percent was paid to CCC’s operations each year, there was confusion between what the association’s investments earned and the spending policy for those investments. By separating investment income from other revenue sources, it was easier to understand whether the 8 percent was earned or paid from capital.

  • To review all reserves together. This has several analytic benefits. First, it allows historic comparisons of the ratio of equities to reserves. It also allows the association to compare itself to other organizations on ratios such as equities to total reserves, equities to long-term reserves, and operating or short-term reserves to total reserves.

• Increase income. Having a better understanding of reserve needs allows organizations to invest in higher yielding securities. DDD is an international environmental advocacy organization with average annual revenues of $3.7 million for the past 10 years. The organization’s expenses averaged $3.6 million during that same time period. Analysis suggested that the worst deficit in 20 years would probably be about $676,000. In the previous 10 years the actual worst deficit had been $494,000.

DDD had $3.5 million invested in CDs and cash equivalents. These short-term investments earned about $45,000 in 2002. By laddering the investments, the annual income was doubled.

DDD increased its income to $95,000 by meeting the expected reserve needs of $494,000 and by investing the remainder in longer term investments. In the current environment, with a steeply rising yield curve, an investor is paid to buy longer maturities if the organization’s risk profile warrants it.

Global perspective

Determining appropriate funding for your reserves should not be done in a vacuum. Look at your historic practices, at how your peers manage their resources, and most importantly, analyze your recent financial history and the levels of reserves they suggest. Reviewing your financial situation in such a fashion ensures that you are ready to face the unexpected.

Resources

• ASAE’s Operating Ratio Report, 11th Ed. (2000) Association for Financial Professionals (provides benchmarking data)

• National Association of Realtors’ “Field Guide to Association Budgets and Reserves”

Peter Louis Jennings is senior vice president at Legg Mason, Washington, D.C. Copyright 2003 Peter Louis Jennings.

Reprinted with permission, ©November 2003, American Society of Association Executives, Washington, D.C.
 

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