BENCHMARKING AND MUNICIPAL RESERVE FUNDS:

THEORY VERSUS PRACTICE

By Michael Shelton and Charlie Tyer with the Assistance of Holly Hembree

 

 INTRODUCTION

Municipal governments exist to provide a wide range of basic services on which we all depend: police and fire protection, streets and sidewalks, water and sewer systems, libraries and parks, to name a few. The ability of cities to provide this wide range of services rests on their financial decisions. In recognition of that fact, local government decision makers, citizens, and the media focus a lot of attention on how much money a city spends and how it raises that money. Put another way, expenditures, taxes, and debt occupy the public's attention. But the attention of municipal finance officials is also focused upon another aspect of government finance--their city's general fund balance.

The very term "fund balance," however, is often misunderstood. Some common misconceptions are that fund balance is a "savings account," an amount of surplus cash, or in less kind terms, a "slush fund." In fact, fund balance is nothing more than an accounting construct. It is the difference between a governmental fund’s current assets—cash, short-term investments, inventories, receivables, and other unrestricted assets expected to be available to finance operations in the immediate future—and its current liabilities. A positive difference of current assets over current liabilities gives an indication of the resources immediately available to finance ongoing operations.


Any fund balance which is not appropriated in the following year's budget for specific expenditures and which is not designated or reserved for specific purposes serves as a general operating reserve for the governmental entity. Determining an adequate level of unreserved general fund balance is one of the more difficult questions policy makers and finance professionals confront. In part this is due to conventional wisdom and the prescriptions it provides.


The purpose of this article is to examine the level of unreserved fund balance in municipal governments in North and South Carolina. The assumption is that based upon previous research on local government fund balances, the conventional wisdom will be found to be inadequate in many cases to serve as a policy guide for local government decision makers. In return, this article suggests that local officials consider benchmarking as an aid in establishing individual city fund balance policies. While benchmarking has received widespread attention as a technique for improving governmental service delivery or administration, it has not been discussed as a technique for making policy decisions in this area of municipal finance.

CONVENTIONAL WISDOM AND RESEARCH

Search most texts and note the attention devoted to reserve funds. Typically one will find none regarding local government, or if there is a reference it is often to something called a "contingency fund" or "rainy day fund." The paucity of research and literature about local government reserve funds has been acknowledged by the Government Finance Officers Association (GFOA) in a Research Bulletin published in 1990 which focused on the use of unreserved fund balance.1 Research on large cities in the United States has shown that few formally establish a reserve fund.2 Instead, they rely on their fund balances for that purpose. South Carolina and North Carolina cities are no exception to this practice.


Searching in the public finance literature for help when a jurisdiction wants to establish a policy on reserve fund balances can be confusing. This is because no distinction is often made between contingency funds and reserve funds. Most of our budgeting literature, and particularly the local government literature, refers to contingency funds. For example, James Gosling writes: "Local policy makers have an incentive to build a politically acceptable surplus into the budget. A surplus provides a "contingency" against revenues falling short of estimates." 3 Michael Wolkoff, in one of the few published research pieces on municipal reserve funds, clearly equates them with rainy day funds.4 He found few such formal funds at the municipal level, but did acknowledge that cities may be maintaining general fund balances as a surrogate for a rainy day fund. And, Ian Allan, writing for GFOA describes the use of unreserved fund balance as money generally available for "contingencies" in the event a government experiences financial difficulty.5 Irene Rubin, has written that year-end surpluses, combined with contingency funds, seldom exceed eight to 10 percent of a local budget (presumably referring to the general fund budget). 6 Finally, David Osborne and Ted Gaebler in their bestseller, Reinventing Government, write about "anticipatory government" being necessary today. They note, correctly, that politicians are bombarded with problems than an individual or an interest group wants solved on a short-term basis. Thus, most governments in the United States fail to plan beyond one year at a time, particularly in terms of their budgets, which are almost universally annual budgets and are not viewed in the context of any kind of overall plan.


One way of anticipating the future, according to Osborne and Gaebler, is by "long-term budgeting," or multi-year budgeting, something they imply few governments do. But, they then proceed to acknowledge that there is another, indeed more common, way that local governments anticipate the future. This is by the use of reserve funds, although they too refer to these in the context of "contingency funds" or "rainy day funds."7


Thus, several examples exist of authors dealing with local government budgeting and finance either confusing reserve funds with contingency funds, or failing altogether to understand that there may be a distinction between the two concepts. Reserve, contingency and rainy day funds are not necessarily the same. Contingency and rainy day funds do share some similarities, and they are forms of reserve funds. But, and this is the key distinction, a reserve fund is not necessarily a contingency or rainy day fund. Rather, reserve funds can be for any number of purposes while contingency and rainy day funds are for unexpected contingencies, emergencies, or revenue shortfalls, in short, forms of uncertainty. All of these funds, however, are intended to help local governments accomplish two goals: achieve tax stability and contribute to the orderly provision of services.
Various "rules of thumb" are commonly used to evaluate the adequacy of a local government’s unreserved, undesignated balance. A commonly cited standard is five per cent (5.0%) of annual operating expenditures. Others argue that the standard should be anywhere from one month’s operating expenditures (roughly 8.3% of budgeted operating expenditures) to three months’ expenditures (about 25%).8


In North Carolina, the state recommends that local governments maintain minimum unreserved fund balances of 8.0%.9 Consistent with its home rule philosophy, South Carolina law specifies no minimum fund balance levels for local governments beyond the constitutional requirement that a local government raise taxes to remedy a deficit following any year in which a deficit occurs.10 Each local entity is free to determine its own policy, or not to use a specific policy, with regard to the management of its fund balance. Some, as we report in this article, integrate the assessment of long-term impacts upon fund balance into their financial planning and budgeting.

RATIONALES FOR MAINTAINING A POSITIVE FUND BALANCE

Why does a city need a positive fund balance? (Note that the word "positive" is used here. A negative fund balance can exist which indicates a deficit.) There are several reasons. First, a fiscal year is an artificial construct used for budgeting, control, and financial reporting purposes. Expenses do not cease simply because we change fiscal years. A city has to continue to pay employees and operate. Revenues in the new fiscal year often do not come in precisely when they are needed. For example, property taxes in many cities aren't received until early in a new calendar year. For a city which uses a fiscal year beginning July 1st, this is six months (or more) into the fiscal year. Other revenue sources have their own collection cycles. It is not uncommon, therefore, for a local government to have a negative cash flow in some portions of its fiscal year. This simply means that more money is being paid out than is coming in. Fund balance accumulations from prior years would typically be used to finance these expenditures. As revenues come in, of course, these funds are restored to the fund balance so long as the government is living within its budget and revenues meet projections. Thus, cash flow needs dictate a need for a fund balance. Of course, local governments can finance these cash flow needs with short-term debt in the form of tax anticipation notes, but interest, debt issuance costs, and potentially increased costs of long-term borrowing make this make this a more expensive alternative.

A second reason for maintaining a positive fund balance is that many governments it as a means of financing large capital expenditures, such as vehicles and other equipment, land acquisition, and buildings or building maintenance projects. Building up a positive fund balance over time may eliminate the need for entering into debt, or at least reduce the amount of debt needed when capital expenditures are required, thereby reducing the interest charges the government will pay. In addition, a positive fund balance allows an entity to plan ahead for major expenditures and to smooth the tax rate out as much as possible, so that erratic fluctuations in property tax rates or other revenue sources need not occur.

A spin-off benefit of a fund balance is that it also provides government with funds to invest in order to earn interest income. Such income is a revenue source that can be used to maintain lower taxes. Thus, when cash is temporari1y idle, wise investments can provide a valuable source of revenue for a city.

Finally, a positive fund balance can indeed serve as a contingency fund which enables the governmental entity to respond to unanticipated events or emergencies during the years. Buildings or equipment may be damaged through unexpected events. An emergency may require more employee overtime expenses than budgeted, such as occurred in 1989 when Hurricane Hugo struck South Carolina. Or, opportunities may arise which a government may want to take advantage of (i. e., park land, a historic site, or surplus equipment offered for sale) but which were not anticipated when the budget was prepared.

Thus, there are many sound reasons for a government to maintain an adequate fund balance. At the same time, it is also possible for a governmental entity to accumulate an excessively large fund balance. An excessively large fund balance would be one beyond the contingency and cash flow needs of the community in the short term, and which lacks any planned use for other longer term projects or expenditures. In such a case, taxpayers are either paying unnecessarily high taxes or other charges, or they are not receiving an adequate return on their tax dollars in services and facilities. Hence, the need for city policy makers to engage in some type of planning, but also to have some yardstick to use to set a general fund balance policy. One yardstick which can be used is to look at what other cities maintain as a fund balance. This is done here by using cities in North and South Carolina.

MUNICIPAL FUND BALANCES IN NORTH AND SOUTH CAROLINA

Under the auspices of the University of South Carolina's Institute for Public Service and Policy Research, Center for Governance, during 1998 data was collected on municipal general fund balances in North and South Carolina for fiscal year 1997. North Carolina is unique in that the state requires that local governments report detailed information each year to a state agency, the Local Government Commission.11 The North Carolina Local Government Budget and Fiscal Control Act provides a formula that cities and counties must use to calculate the maximum fund balance that is available at the end of one fiscal year for appropriation in the next year's budget. Today, the State Treasurer's office in North Carolina collects this information on behalf of the Commission annually.


North Carolina calculates and reports "available general fund balance" for its cities according to a standard formula. Available fund balance is different from the fund balance or fund equity shown in financial statements. North Carolina provides that available fund balance shall not exceed "the sum of cash and investments minus the sum of liabilities, encumbrances, and deferred revenues."


South Carolina has no comparable state agency to the Local Government Commission, nor does it rigorously oversee the annual collection of municipal financial data in a standard format that can be comfortably used for research and data analysis purposes. Therefore, this study selected a sample of cities and directly collected their audit or financial report for fiscal year 1997. To assure as much comparability as possible with the North Carolina data, the data was adjusted by deducting reservations of fund balance and other commitments that reduced the amount of general fund balance available for appropriation. Thus, this study uses all North Carolina cities but a sample of South Carolina cities due to the difficulty of data collection.


North Carolina has considerably more cities than does South Carolina, and they are also distinguished by the fact than more cities in North Carolina own and operate electric utilities. North Carolina has 70 cities that provide electric utility services to their citizens. South Carolina has only 21 such cities. Since South Carolina has a much smaller number of electric cities, and since they are distributed across population categories used in this study, this study did not separate them from the remaining cities. The practical significance of the distinction for this research is that electric cities, as a rule, may keep lower general fund balances, especially if they regularly make operating transfers from the electric utility to the general fund.


Tables 1 and 2 provide an overview of the number of cities in North and South Carolina by population size, and the sample used to study the South Carolina cities. Tables 3 and 4 provide the results of this study by comparing the sample cities in South Carolina to the cities of North Carolina. Table 4 introduces the concept of "central range" as an aid in using the data collected. The central range standard is simply the range of fund balance to expenditures into which half of the cities in each population category fall. Stated otherwise, this means that half the cities fall outside this -- a quarter above it and a quarter below it -- and half are within the range. Thus, the range can be taken as a general guide that the jurisdiction may alter to fit its particular needs, taking into consideration other funds that may be available outside of their general fund, and the revenue mix of the jurisdiction, and the jurisdiction's own peculiar cash flow patterns.


What the data tends to suggest is that municipal fund balances typically ranges from 20-50% in South Carolina, and much higher in North Carolina, and that there is an inverse relationship between size of jurisdiction and percentage of fund balance retained. The smaller the city, generally, the greater the amount of its fund balance in proportion to its operating expenditures. In addition, cities with electric utilities (electric cities), especially the smaller cities, tend to keep significantly less general fund balance available than the non-electric cities, perhaps indicating a reliance upon transfers from the electric utility for financing temporary cash needs.


In almost all population groupings, the ranges are considerably higher than most of the targets suggested by conventional wisdom and in the policy statements we examined. While it may be tempting to conclude that this means cities are systematically maintaining excessive levels of fund balances, several follow-up interviews disclosed legitimate reasons for the accumulations in a number of cases. Some had allowed balances to accumulate toward the construction of major new municipal facilities. Some were accumulating funds for capital equipment replacement (a single fire engine costing a quarter-million dollars can make up a significant percentage of a smaller jurisdiction’s budget). Some had established designations for self-insurance. In short, many had legitimate public policy reasons for accumulating what otherwise appeared to be unusually large fund balances.

The real purpose of reporting actual data here is to suggest that local officials can consult comparative data between themselves and a benchmark group or groups for guidance on how much fund balance to maintain. Benchmarking with other cities that are similar in population size, services provided, and revenue mix is a valuable gauge to use in establishing a fund balance policy. In other words, local officials can get a good start on establishing reasonable fund balance policies by observing the prevailing practices in other jurisdictions. As with other kinds of benchmarking efforts, the comparison itself may raise more questions than it answers. Differences between states, and over time, along with the myriad of reasons why governments retain the levels of fund balance they do, may point out many areas a jurisdiction will want to investigate as it formulates the "right" policy for itself.

Other cities in a benchmark group may also have policy statements they can share to help a local government in tailoring its own policy. While little uniformity is to be expected in policy statements across jurisdictions, some common themes should readily appear, even if only a few samples are available. Whey they began this study, the researchers solicited copies of the annual budgets along with statements in any form that addressed the jurisdiction's approach to fund balance policy. The solicitation went to all South Carolina counties and to cities with populations of more than 10,000. Slightly over half of these 30 cities and 46 counties responded. Five of those respondents used some form of written policy or general guideline on fund balance. Some were incorporated into the annual budgets or long-range plans. Some were codified in the city's Code of Ordinances. Interestingly, although the policy statements varied as to form, most contained four common elements: (1) a policy rationale, usually addressing cash flows or potential emergency needs; (2) a target minimum balance or a target range; (3) permissible uses for surplus funds; and, (4) provisions for restoring the balance should it fall below its targeted minimum. A sample statement synthesized from these five local government fund balance policies appears in Table 5.

Two of the respondents (Greenville County and the City of Myrtle Beach, South Carolina) integrated into their long-term plans an analysis of the future impacts of current service decisions and planned capital improvements upon general fund balance. This allows the entity to evaluate the likelihood that it will be able to absorb changes in levels of service within its current revenue base. If the increases cannot be absorbed, the need for tax and rate increases can become a part of the policy agenda and receive some public debate well in advance of the time when they will be needed.

CONCLUSION

What does this mean for local government officials? First, elected officials need to make a conscious decision about how large a balance they need to cover their cash flow and contingencies each year. Next, they need to anticipate capital outlay and capital project needs and have a plan for financing those needs. If operating revenues are to be used, are such funds available from annual revenues? If operating revenues will be the financing vehicle and the annual budget cannot accommodate those needs, it would be prudent to plan ahead and designate portions of their reserves, or fund balance, to assist in such purchases. Such a decision will give a community time to assure that money is available when those expenditures must be made.

The operative word here is planning. Assuming basic liquidity needs are met, the target fund balance range itself is less important than the fact that the community has a policy and periodically gives it conscious review. It is important that the elected officials and staff have given constructive thought to the reasons for maintaining a fund balance, that they have considered what size balance is right for their community, and that they understand and are reasonably prepared to deal with the risks inherent in whatever policy they craft.

 

Table 1

North Carolina and South Carolina Cities By Population Size

Cities

N. C.

S. C.

50,000 or more

14

4

10,000 to 49,999

44

26

2,500 to 9,999

109

63

1,000 to 2,499

120

46

500 to 999

96

43

Less than 500

131

87

Total

514

269

 

 

 

Table 2

South Carolina Cities, 1997 Study Sample

Cities

Grouped by Population

No. of Units

Sample

50,000 or more

4

4

10,000 to 49,999

26

18

2,500 to 9,999

63

19

1,000 to 2,499

46

16

500 to 999

43

15

Less than 500

87

17

269

89

 

  

 

Table 3

Comparison of N. C. and S. C. Cities Average Fund Balance

As a % of General Fund Expenditures in FY 1997

 

N. C.

N. C.

S. C.

Electric Cities

Non-Electric Cities

All Cities

Population
50,000 or more

25%

27%

26%

10,000 to 49,999

39%

41%

32%

2,500 to 9,999

35%

79%

47%

1,000 to 2,499

48%

97%

48%

500 to 999

57%

218%

39%

Less than 500

71%

266%

151%

Note: Only 21 South Carolina cities own and operate an electrical utility while 70 North Carolina cities do. Thus, South Carolina cities are grouped together.

 

Table 4

Central Range for Available General Fund Balances

As a Percentage of General Fund Expenditures, Fiscal Year 1997

Cities

N. C.*

S. C.

50,000 or more

18-26%

22-27%

10,000 to 49,999

34-44%

25-43%

2,500 to 9,999

35-82%

18-63%

1,000 to 2,499

40-90%

19-36%

500 to 999

48-163%

31-50%

Less than 500

97-325%

57-161%

*N. C. cities include only non-electric cities for this comparison.

 

 

 

Table 5

Sample Fund Balance Policy adapted from Selected South Carolina Local Governments

To secure and maintain investment grade credit ratings, meet seasonal shortfalls in cash flow, and reduce susceptibility to emergency or unanticipated expenditures or to revenue shortfalls, the Local Government will adopt budgets that provide for unreserved undesignated fund balance of not less than ten (10.0%) nor more than twenty per cent (20.0%)of operating expenditures.

In the event the fund balance is greater than 20.0%at the end of any fiscal year, the excess may be used in one of or a combination of the following ways:

· One-time expenditures which do not increase recurring operating costs;

· Other one-time costs, or the establishment of or increase in legitimate reservations or designations of fund balance;

· Start-up expenditures for new programs undertaken at mid-year, provided such action is considered in the context of council-approved multi-year projections of revenues and expenditures.

If at the end of a fiscal year, the fund balance falls below 10.0%, the City Manager shall prepare and submit a plan for expenditure reductions and/or revenue increases to the City Council. The City shall take action necessary to restore the unreserved, undesignated fund balance to acceptable levels within one year

Sources from whose responses this sample statement was derived include the cities of Mount Pleasant, Myrtle Beach, Spartanburg and Union, and Greenville County, South Carolina.

 

 

Notes

1.  Ian J. Allan, "Unreserved Fund Balance and Local Government Finance," Research Bulletin (Washington, D. C.: Government Finance Officers Association, Nov. 1990).

2.  Michael J. Wolkoff, "An Evaluation of Municipal Rainy Day Funds," Public Budgeting and Finance 7 (Summer): 52-63.

3.  James J. Gosling, Budgetary Politics in American Governments (New York: Longman Publishing Group, 1992), 130.

4.  Wolkoff, op. cit.

5.  Allan, op. cit.

6.  Irene S. Rubin, The Politics of Public Budgeting: Getting and Spending, Borrowing and Balancing (Chatham, N. J.: Chatham House, 1990), 203. Rubin does not discuss fund balance generally in her second and third editions of this book, but does refer to contingency funds and rainy day funds.

7.  David Osborne and Ted Gaebler, Reinventing Government: How the Entrepreneurial Spirit is Transforming the Public Sector (Reading, Mass.: Addison-Wesley, 1992), 219-249.

8.  Local government managers, in interviews and conversations, frequently refer to three months general fund expenditure being a guide for a local government's general fund balance.

9.  The North Carolina State Treasurer’s Office recommends that local governments retain minimum fund balances of 8% of annual expenditures. Fund balances are monitored annually by the Treasurer’s Office. Local Governments are encouraged to compare themselves with other local governments and to consider whether their retained balances are sufficient to meet their needs. When balances fall below the 8% level, the Treasurer’s Office writes to inform the government that it has noted a situation that may indicate liquidity problems.

10. Constitution of the State of South Carolina, Article 10.

11. The North Carolina Local Government Commission was created in 1931 to oversee local government debt. It also requires local governments to follow generally accepted accounting principles and counsels them on good financial management practices.

Readers may want to consult also some previous research on the general issue of local government reserve funds. These would include:

Jane Massey and Charlie Tyer, "Local Government Fund Balances: How Much is Enough?" The South Carolina Forum 1 (April-June, 1990): 40-46.

Charlie Tyer, "Municipal Enterprises and Taxing and Spending Policies: Public Avoidance and Fiscal Illusions," Public Administration Review 49 (May/June, 1989): 249-256.

Lee Carter and A. John Vogt, "Fund Balance in Local Government Budgeting and Finance," Popular Government 54 (Winter, 1989): 33-41.

Michael Shelton is Budget and Evaluation Director for the City of Myrtle Beach, S. C.  Charlie Tyer is a Senior Fellow in the Center for Governance at the Institute for Public Service and Policy Research, University of South Carolina, and faculty member in public administration.  Holly Hembree is a graduate research assistant in the Center for Governance.