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Rethinking Fiscal Reserves

June 27, 2023

By Vincent Reitano, Associate Professor - School of Public Affairs and Administration, Western Michigan University and Shayne Kavanagh, Senior Manager of Research for GFOA

Even though many state and local governments appear to be flush with cash thanks to a host of new funding streams from the federal government, they continue to face financial risks from a range of sources. Legacy employee costs, including pensions and post-retirement health care, for example, cast a shadow on their fiscal futures. Uncertainties loom as well, such as the potential for economic downturns and cybersecurity attacks.

Preparing for a world full of both predictable and unpredictable threats to financial health requires careful consideration of fiscal reserves, which can be accumulated and then used to respond to financial difficulties. From a budgetary perspective, they are a form of fiscal slack that can be used on a discretionary basis. How best to accumulate and use fiscal reserves is an ongoing question that has long garnered significant attention from practitioners and academic researchers and is of particular consequence now.

Over the past two decades, guidance from professional organizations such as the Government Finance Officers Association (GFOA) has typically conceptualized fiscal reserves from a savings model perspective in which governments accumulate savings over multiple years, and then use them when needed.

While important and influential, the savings model may not compel budget and finance officers to consider reserves in relation to risk. For example, setting a target level of reserves but not quantifying specific risks (e.g., volatility of revenues, natural disasters, economic downturns) neglects the question of why governments are actually accumulating reserves for their specific needs. A newer insurance model perspective can help answer the question and complement the savings model perspective to create a savvy financial strategy.

A new GFOA Research Report,  Should We Rethink Reserves: A Multi-Million Dollar Question considers the benefits and flaws of the traditional savings model. Specifically, the report states that: “Indeed, the savings account has several advantages as a mental model. First, it’s an easy analogy to grasp for people who are not public finance experts. Second, it has a seemingly obvious parallel to the personal lives of local governments’ stakeholders. This is particularly true for the “sinking fund” function of reserves, as most people have experience with building up their personal savings to pay for some consumer expenditure or personal investment (e.g., education, house, car, etc.). However, the savings account model has disadvantages as well. First, the analogy to personal savings as a buffer against risk might not be as powerful as it seems. Personal savings rates have been in long-term decline.

“Not only that, but most consumers also start saving reactively, after an adverse event has occurred (e.g., recession, pandemic). Obviously, this is not a viable strategy for local government reserves.”

The report suggests that governments rethink reserves using an insurance model perspective. “This does not necessarily replace the savings account model,” the report states, “but does supplement it by providing a new and better perspective on some of the most important purposes of a reserve. Insurance has an obvious parallel to people’s personal lives. Given that local governments hold reserves to manage risk, insurance is an accurate analogy for reserves. Further, insurance is purchased proactively, before an adverse event occurs; much like reserves must be built up ahead of time to prepare for future, unpredictable adverse events.”

For example, the insurance model leads to the use of risk-based reserves analysis. Given the challenge of precisely estimating risks and the need to accommodate different risk appetites, this analysis requires a shift from reliance on a single target reserve level (e.g., 15%) to a range (e.g., 15 to 25%). Then, a government needs to estimate specific risks they may face, potentially, by using quantitative or qualitative risk assessment tools.

Governments can consider identified risks (e.g., local blizzards or wildfires) in relation to self-insurance (fiscal reserves) and commercial insurance. Reserves lend themselves to lower magnitude, higher frequency risks. Commercial insurance lends itself to risks with catastrophic losses that would strain or even exceed reserves. As a result, examining he severity of risk can help governments to consider pricing efficiencies between retaining reserves or going to an insurance marketplace.

The Research Report also examines the relationship between reserves and bond ratings. “Bond ratings are often used as a reason to maintain high reserves,” it explains. “However, the interest rate advantage will only be justified under certain conditions. Reserves as insurance asks us to consider if higher reserves are ‘worth’ the cost to obtain a higher bond rating.”

Conducting risk-based reserves analysis, examining self-insurance and commercial insurance, and considering the impact on bond ratings are just three applications of the new insurance model. There are other applications discussed in the report such as adopting a comprehensive reserves policy, risk-pooling, and optimizing investments with information technology tools. In relation to the savings model, these approaches reflect a newer way of thinking about fiscal reserves. They may also help to better communicate fiscal reserves to different stakeholders.

For example, amidst declining trust in government, residents may question the opportunity costs of accumulating reserves over multiple years. Further, elected officials might be concerned about the optics of maintaining large fiscal reserves. Applying the risk-based reserves analysis and communicating key findings to residents and elected officials may help to bolster trust in government, if community members are able to understand the reasoning behind accumulating reserves and/or purchasing commercial insurance.

The GFOA Research Report concludes with the following: “We have advocated that local governments treat reserves more like self-insurance, including using insurance metaphors to discuss and plan reserve strategies, using risk analysis to determine the size of the reserve, complementing reserves with commercial insurance strategies, pooling risks that reserves are used to cover, and more.”

At its core, the insurance approach allows for a more informed way of looking at fiscal reserves, by accounting for the many risks and uncertainties that governments may face.

The contents of this blog post reflect those of the author, and not necessarily those of the GFRC.