September 15, 2023
The Government Finance Officers Association (GFOA) recently published a report entitled Should We Rethink Reserves? A Multimillion Dollar Question recommending that governments use risk analysis techniques to optimize the use of their reserves beyond adhering to traditional reserve standards. This approach can allow governments to tailor their reserve needs to their particular circumstances rather than following a “one size fits all” policy. The considerations in the report are based on lessons learned from GFOA’s consulting work with governments as well academic research.
Reserves Versus Fund Balance
The terms reserves and fund balances are often used interchangeably, but they have different meanings.
Reserves is a budgetary policy term that describes additional available, liquid resources, such as cash and investments outside the budget, to be used if appropriated funds are insufficient. These funds may be used for contingencies, emergencies or other unplanned events.
Fund balance, however, is an accounting term referring to the difference between assets and liabilities, or the net position of governmental funds calculated according to generally accepted accounting principles (GAAP). GAAP establishes five components of fund balance. The first two, nonspendable and restricted fund balance, are resources that cannot be spent because of legal or contractual restrictions. The remaining three components—committed, assigned and unassigned fund balance—involve constraints that can be lifted by the government and used for any purpose.
Current GFOA Fund Balance Policy
GFOA has recommended for many years that general purpose governments maintain unrestricted budgetary fund balance in their general fund of at least two months of regular general fund operating revenues or regular general fund operating expenditures. A lower unrestricted fund balance may be appropriate for states and larger governments, such as cities and counties, because they can often better predict contingencies and they typically have diverse revenue streams.
GFOA also recommends that governments establish a formal unrestricted fund balance policy that considers the government’s specific circumstances. Factors to be considered in fund balance policy include: revenue predictability and expenditure volatility; perceived exposure to one-time disasters or immediate expenses; the potential drain on general fund resources from other funds and the availability of resources in other funds; the potential impact on the government’s bond rating and borrowing costs; and funds that are already committed or assigned for specific purposes.
The rating agencies associate the level of ratings with fund balance amounts. For example, Moody’s associates an "AAA" rating with fund balances in excess of 35% of revenues, the “Aa” rating with fund balances between 35% and 25% and the “A” rating with 25% to 15%. However, factors other than fund balance, such as economic conditions, debt management policies, administrative issues and financial performance also contribute to ratings. Overall, a majority of the ratings evaluation is based on factors other than the size of fund balance.
Many Chicago area governments have developed formal unreserved fund balance policies or “rainy day” funds to mitigate financial risks and revenue shortfalls. For example, Cook County’s reserve policy maintains an unassigned fund balance in the General Fund of no less than two months (16.67%) or “floor,” and a “ceiling” of three months’ worth (25.0%) of the General Fund’s total expenditures, plus total other financing uses (e.g. transfers out) from the most recent audit. If the unassigned fund balance drops below the two month “floor” of audited General Fund expenditures, the policy directs the County to develop an action plan to replenish the fund balance in coordination with the annual adopted budget. If the unassigned fund balance exceeds the three-month “ceiling,” the County can use these funds to pay for nonrecurring expenses, an outstanding liability (i.e., pensions or bonded debt) or transfer it to a committed or assigned fund balance in the following fiscal year. The County’s policy indicates that it will also maintain an assigned fund balance for purposes of a Pension Stabilization Fund. This fund is used to offset unanticipated increases in the pension contributions to the Cook County Pension Fund.
Why Rethink Reserves?
The GFOA recognizes that its longstanding best practice guidance on reserve levels may not be individualized enough to optimize a government's reserves based on local risk factors.
GFOA cites four reasons why governments should rethink their strategies on reserves.
- There is increasing uncertainty and volatility in the world, particularly as related to economic disruptions and severe weather.
- There is a growing lack of public trust in governments and experts. This can be manifested in opposition to governments holding large reserves rather than using those resources for current expenses.
- Government increasingly face serious resource constraints, driven by rising employee benefit costs, legal restrictions on revenue increases and stagnant revenue growth. These limits suggest that governments reconsider the use of all resources, including reserves, to meet these financial demands.
- Advances in information technology allow governments to better analyze and devise optimal reserve strategies.
Risks Governments Face
Governments face a number of risks on an ongoing basis, including risks related to financial and economic disruptions such as a recessions or rising pension costs, public health emergencies such as the COVID 19 pandemic, public safety challenges such as rising crime rates and severe weather events such as hurricanes, fires, flooding and snowstorms.
Reserves are an important tool for helping to manage these risks. However, GFOA believes there are several issues with the traditional model of using reserves as savings accounts, rather than as a risk management tool. Focusing on savings ignores the issue of opportunity costs, in which the governments forego potential benefits by choosing one alternative over another. Also, taxpayers may object to governments holding large reserves rather than using funds for current expenses or cutting taxes. Reserve funds might be better used to benefit the current generation of taxpayers if they are used now.
Given these considerations, GFOA suggests that governments consider using an insurance model as the basis of determining the appropriate levels of reserves rather than the current focus on a savings account model. They should not discard the traditional model of using reserves as savings accounts for cash flow purposes, contingencies or a sinking fund to accumulate resources to “prepay” for desired capital investments or programs. Rather, they should consider adopting a more comprehensive and nuanced approach that employs reserves as a self insurance strategy and also considers using commercial insurance policies to supplement reserves for events with potentially severe consequences with a lower probability of occurrence. In sum, self insurance and commercial insurance strategies can complement each other to optimize a government’s risk strategy.
Strategies to Rethink Government Reserve Policies
GFOA recommends that governments consider the following strategies to rethink and adjust their reserve policies.
Risk-Based Reserve Analysis. Governments should develop a risk-aware reserves policy to help determine the appropriate level of reserves. This requires conducting a qualitative or quantitative risk assessment. GFOA notes that governments should think of a reserve funding target as a range instead of a single point to accommodate some of the uncertainty in risks. While some governments may possess in-house expertise, conducting a risk analysis may require the services of a consultant.
Develop a Comprehensive Reserve Policy. A formal policy should be developed based on the results of the risk analysis that defines the minimum and maximum amount of reserves.
Optimize the Combination of Commercial Insurance and Self-Insurance. Because the risk-based approach can help identify the amount of reserves needed based on the risk potential, the governments can more easily consider whether to hold reserves or purchase private insurance to mitigate risks.
Optimize Investment Strategies. A risk analyzer can more accurately determine how much liquid resources are needed to mitigate risk, thereby freeing up resources for higher yield, less liquid investments.
Develop External Risk Pools. Governments should consider developing intergovernmental risk pools to realize cost savings.
Understand Bond Ratings and Reserves. Governments should use risk analysis to determine if high reserves are worth the cost to maintain bond ratings or if the funds could be better used for other purposes.