We recently reviewed a GFOA post from May titled “Should We Rethink Reserves.” We wrote previously on the importance of fund balance, but the GFOA article encourages a more granular analysis of reserve levels than we have discussed. As the need for local governments to allocate resources efficiently becomes more important than ever, every part of the balance sheet must be scrutinized — and local governments need to optimize their reserve strategies.
To adapt to the changing environment, GFOA argues for adjusting what they dub your “mental model” on reserves (meaning, the way you frame the issue to guide your decision-making process). Instead of the conventional wisdom to imagine your unassigned fund balance as a simple, undifferentiated savings account to cover cash flow, to draw from in times of need and to save towards a goal, think of it as having multiple purposes. Evaluating your fund balance across the different purposes can help clarify your views on what you need and when to use it.
While the savings mental model has its advantages, particularly in its simplicity and clear similarities to most people’s personal lives, we agree with the article’s conclusion that it’s appropriate to further break down your reserve analysis. Once you have enough money to cover your cash flow needs (and you’ve placed money held for a particular future project in a capital reserve fund), how much more do you need, and what do you need it for?
The article suggests we think of the reserves as a type of insurance. Shifting our mental model on reserves away from savings and towards insurance, we’re able to better ascertain our optimal amount of reserves. Whereas with savings, more usually is better, local governments will face a point where additional dollars would be better served being put back into the community.
Many of the risks local governments face border on impossible to insure through typical commercial insurance, leaving your reserve fund as the last line of defense for your community. Revenue uncertainty resulting from economic downturns, public health crises, or otherwise poses a major cash flow risk, especially for local governments that rely heavily on a singular large employer in your area or tourism.
Natural disasters also pose a significant risk. While FEMA and other bureaucratic agencies will reimburse costs of cleanup and recovery, GFOA found these reimbursements took on average 18 months to arrive, putting a strain on even the most prepared communities. Less severe events that may not necessarily warrant disaster relief, such as an unusually heavy snow or tropical storm season may exceed expected expenditures and necessitate the use of reserve funds to soften the blow.
Thinking of reserves as insurance also encourages local governments to actually use the reserves when the situation calls for it. GFOA noted that only 25% of the 600 midsized cities drew upon their reserve balances during the Great Recession. If you aren’t going to use your balance then, when will you?
Combining the simplicity and ease of the savings model with the risk management aspect of the insurance model will help you and your community think about reserve policy in a more complete way.
The principal author of this blog post is our Finance and Management Associate AJ Jessup.