Author: Financial Management Resource Bureau
The DLS Financial Management Resource Bureau (formerly the Technical Assistance Bureau) has offered financial management advice to municipalities across the state for over 30 years. To share this guidance more broadly, we thought it would be helpful to highlight some of our more useful, timely, or interesting recommendations for the benefit of City & Town readers.
Cities and towns should manage reserves based on sound formal policies governing their funding, use, and replenishment. Over the last two years, communities have followed conservative budgeting practices, delayed capital investment, and seen an influx of federal assistance which has resulted in historically high reserve levels. Therefore, as we enter this next season of municipal budgeting and financial planning, and with anticipation gaining for an economic downturn, it is more important than ever for local officials to review and update their strategy on building and expending reserves.
When well-planned, a community can use its reserves to protect from the usual unevenness in revenue and expenditure patterns that occur with changes in economic conditions, finance emergencies and other unforeseen needs, accrue money for specific future purposes, or in limited instances, serve as revenue sources for the annual budget. It is important that communities maintain financial flexibility to ensure they are in a position to react and respond to financial challenges without incurring significant financial stress. In all cases, reserves should be used to fund unanticipated or one-time costs rather than to regularly fund operating expenses unless provisions are made to replenish the reserves. The following reserve types are available to communities to support financial stability.
- Annual Reserve Funds – Cities, under M.G.L. c. 40, §5A and towns provided by M.G.L. c. 40, §6 establish reserve funds appropriated as part of the annual budget, to provide for extraordinary or unforeseen expenditures. The purpose of this reserve is to meet unexpected increases in departmental operational costs, such as legal fees, major equipment repairs, and unanticipated increases in service costs. The amount of appropriation reflects a financial management decision. During difficult economic periods, a higher reserve can meet the expectation of more frequent transfer requests from departments that struggle with lean budgets. During periods of revenue growth when departments are given more spending latitude, the likelihood of fewer requests justifies a lower reserve balance. Given the diverse range of financial conditions among communities, there is no consensus best practice on an appropriate reserve fund size, either in absolute dollars or as a percentage of the total budget. Historical practice can serve as a guide if reserve fund transfers have been tightly managed under consistent rules.
- General Stabilization Funds – Communities establish general stabilization funds (M.G.L. c. 40, §5B) as reserve accounts to provide emergency funds for use in a major or significant event, such as natural disaster, an uninsured loss, damage to a capital asset, or prolonged decrease in revenue. Although a general stabilization fund may be appropriated for any lawful purpose, withdrawals should be limited to mitigating emergencies or other unanticipated events that cannot be supported by current general fund appropriations. A community’s target balance for a general stabilization fund varies by budget, experience, and other available reserves. A recommended goal is typically in the five to seven percent of the current operating budget range.
- Special Purpose Stabilization Funds – A community can create special purpose stabilization funds and designate specific allowable expenses. The most common special purpose stabilization fund is for funding capital related project, equipment, and maintenance. Other special purpose funds include vehicle replacement, technology upgrades, and road maintenance. Target balances should be defined based on the specific purpose and expenditures; however, these reserves may be supported by dedicating a particular fee, charge, or other receipt to provide a consistent funding source. More information on stabilization funds can be found via the link.
- Free Cash – Free cash is the remaining, unrestricted funds from operations of the previous fiscal year, including unexpended free cash from the prior year, or simply the available fund balance in the general fund as of June 30. Because free cash is based on the annual financial operations as certified by the Bureau of Accounts, the amount of certified free cash cannot be known with certainty during the fiscal year. Therefore, we recommend that as much as practicable, communities limit their use of free cash to funding one-time expenditures (e.g., capital projects, snow and ice deficits, or emergencies), or use it to fund other reserves. Further, we recommend defining a target balance for free cash certification as a percentage of the general fund budget, such as five to seven percent, and striving to keep a targeted year-end unappropriated free cash balance to fund the next certification.
- Other Continuing Balance Accounts – State statue allows communities to establish accounts that protect against financial consequences of certain risks and liabilities. These include the account for allowance for abatements and exemptions, known as the overlay, and accounts for future expenses for unemployment compensation, workers’ compensation, compensated absences, and retirement. These accounts are not closed at the end of the fiscal year and should be funded and routinely monitored to ensure that the reserves are adequate but not overfunded.
We consistently recommend that communities review and update all financial policies at the beginning of the budget season. Specifically to reserve funds, confirm the policies:
- Establish target balances for the stabilization fund, annual free cash, and other reserves, either as a total dollar amount or as a percentage of the annual budget. It will set a schedule of annual appropriations (e.g., to stabilization) or limitations on use (e.g., of free cash) designed to gradually reach and sustain the target balances over time.
- Direct the use of all or portions of free cash as a funding source for stabilization or as an outlay for one-time capital projects. It can also direct the use of revenue from a specific, recurring income source (e.g., rental income) for a special purpose stabilization fund.
- Restrict the use of unexpected, nonrecurring revenue, or surplus revenue, to one-time costs.
- Restrict the use of stabilization funds to nonrecurring expenditures and only in amounts above a certain dollar threshold. Set similar guidelines on the use of free cash.
- Measure performance to policy statements and determine remedies for noncompliance.
More information on reserve funds and financial planning can be found on our website in Municipal Finance Best Practices Training and Resources webpage.
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Editor: Dan Bertrand
Editorial Board: Marcia Bohinc, Linda Bradley, Sean Cronin, Emily Izzo, Lisa Krzywicki and Tony Rassias
| Date published: | November 17, 2022 |
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