Author: Financial Management Resource Bureau
Managing reserves is a key part of any community’s financial management strategy. DLS has written extensively in the past of the need for sound reserve management and has also published best practices for how to do so effectively. For communities in Massachusetts, reserves are typically comprised of free cash, the stabilization fund, and any specialized stabilization funds. Conventional wisdom around a reserve is to think of it as a “rainy day” fund or a savings account. In this context funds are held back from expenditure and put into reserve to create a buffer against a future loss of revenue or emergency, for an improved credit rating, or to save for the cash purchase of a capital item. In this model, we define a target level as a percentage of annual revenue, and exceeding the target level is generally considered better than missing it since it provides a greater buffer against future risks. However, a recent GFOA article proposes that we reframe reserves as a risk-management strategy and introduces the concept of a reserve as insurance. The addition of some form of risk analysis allows reserve strategies to better target a community’s specific risks.
The article begins by breaking down the basics of what a reserve is: a way to guard against future uncertainty, i.e. risk management. From here it contrasts the traditional savings account model of reserves with a new one as insurance to proactively fund against future risk. The article also points out that this model may have better resonance with taxpayers, who are increasingly distrustful of government and may look with scrutiny at a local government proposing to hold back a significant portion of revenue that could have gone into the local economy or been used to maintain or enhance services. Additionally, economic uncertainty and revenue instability means future budget environments are likely to be more revenue constrained. The decision to hold funds in reserve must be backed up by sound analysis both out of fiscal necessity and to seem legitimate to an increasingly skeptical public.
The GFOA then proposes that communities adopt a reserves strategy that is “risk aware.” A risk aware approach to reserves introduces risk analysis to reserves management, but also includes many best practices that are routinely recommended by DLS. Similarities include adopting a comprehensive reserves policy, setting a range rather than a single number for a target balance, designating specific revenue sources and situations for appropriating into reserves (for instance a dedicated revenue source or a disposition of appropriating a percentage of excess revenue into reserves), and setting specific conditions and restrictions for using the reserve (such as defining an emergency and prohibiting use of the reserve for recurring expenditures). These links provide more information about DLS practices for reserves management:
- Stabilization Funds: Overview and Best Practices
- Introduction to Free Cash
- Financial Indicators: Reserves
- The Importance of Free Cash
- The Importance of Reserves Policies
In the article, GFOA proposes two broad categories of risk analysis: qualitative and quantitative, with the latter being subdivided into “single number” and “probabilistic simulation.” The most accessible version of risk analysis is the qualitative (or subjective) assessment. In this technique a community can review categories of risk and determine what it is most exposed to and most likely to expend reserves to mitigate. The article provides three broad categories for consideration based on GFOA’s experience working with communities in this area: financial/economic (reduction in the rate of return for a pension fund where a community has a significant liability), public health (the COVID-19 pandemic or other outbreaks), and public safety (terrorism, civil disorder, property damage). Other major emergency events include natural disasters/extreme weather, man-made events like hazardous material spills, cyberattacks, or a major upcoming capital infrastructure need.
With a better idea of its risks (the article includes a link to a GFOA template),the municipality can create a targeted estimate for the cost to mitigate each one and plan its reserves strategy accordingly. While this method is simple and accessible, it is not possible to objectively analyze whether the resultant risk exposure is totally accurate or whether reserve levels are truly optimal. However, depending on the community, simply including any risk analysis at all may be beneficial to making reserves decisions without the need for acute mathematical precision.
The first quantitative technique mentioned, single-number, involves identifying a community’s likely risks and then quantifying their potential impact in terms of dollars. For instance, a community may look at a past recession (such as the 2008 Great Recession) and determine that due to that event, revenues decreased by a specific amount (the article uses $5 million as an example) and therefore that number should be part of the basis for determining an optimal reserves amount, given the community’s likely risks. The advantage of this analysis is that it is simple to understand and a community should be able to perform it with its own resources. The disadvantage is that a single number obscures the full range of risks and cannot account for unknowns, or risks that a community does not know it is exposed to. Furthermore, just because an emergency led to a particular loss in the past does not guarantee it will do so in the future.
To account for as many unknowns as possible, GFOA ultimately determines that a “chance-based” analysis based on probabilistic simulations is the most accurate method. In other words, using software to analyze the effects of many different variables on a community’s financial position, from the losses posed by identifiable risks to the effects of cutting spending rather than using reserves to meet an unintended revenue loss, and many other scenarios. This analysis uses computing power to run through a much broader range of risks and scenarios, giving the community a much higher degree of precision in determining its risk profiles and the optimal level of reserves to meet them. However, this method is complex, requires the use of outside tools (the article mentions open-source tools available on the web) and will require staff trained at highly sophisticated level of software programming and Excel. Assuming a community has the requisite expertise, it will need to devote considerable staff time to developing, testing, and verifying the accuracy/usability of any model it produces. Otherwise, the community will likely need to hire a consultant, which has its own costs. Considering the amount of staff time, resources, and organizational focus needed for many Massachusetts communities to simply complete their annual budget process, it is likely that the costs in time and money will outweigh the benefit of this model for most.
Ultimately the complexity, cost, and staff time required for a robust, objective, risk-aware reserves strategy makes it difficult to recommend to the majority of Massachusetts’ 351 cities and towns. Nevertheless, while the specific analytical methods outlined by the GFOA may or may not be relevant to a given community, we believe the overall concept of reserves as risk management, and thus as insurance, is a good conceptual tool. When building cash reserves, communities should have a good sense of what they are “insuring” against both to arrive at an optimal level (weighed against alternative uses) and to be able to justify holding funds back for a skeptical public.
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| Date published: | July 18, 2024 |
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