Financial Policies: A sound business practice for municipalities

(from Maine Townsman, January 2006)
By Lee Burnett, Freelance Writer

Some folks got nervous when the small town of Veazie made plans to borrow big bucks to build a new elementary school in the late 1990s.

The $5.3 million borrowing package would have cost each resident about $2,500 in additional taxes for the life of the bond, a burden at least 25 percent heavier than is generally considered prudent as measured on a per capita basis. The town’s bond counsel warned that the town might even have to buy a special kind of insurance – at an additional cost – to satisfy bond rating agencies.

“Some accused us of exceeding the debt ceiling,” explained Town Manager Bill Reed.

Veazie officials weathered the controversy without much guidance from its written policy on debt, which is little different than the requirements of state law. Veazie officials mounted a public education campaign. They were able to show townsfolk that the borrowing package was quite miniscule when measured a different way.

State law sets a ceiling on municipal debt of 15 percent of the community’s overall equalized state valuation. Veazie’s school debt amounted to just 2.4 percent of its total tax base of $217 million, and really even less than that since the state would kick in a big share of the annual payments. Town officials also showed that the debt would still be a reasonable load even if the town lost one of its biggest taxpayers, Bangor Hydro.

“I think everyone felt comfortable after looking at the type of debt,” said Reed.

While Veazie found its way despite having a weak municipal debt policy, other municipal officials and finance professionals say life is made much easier by having detailed financial policies on not just debt, but cash flow management, investments, and purchasing. These policies can help resolve conflicts, reduce guesswork, provide stability through personnel turnover, foster confidence in overall management and yes, save money, according to municipal finance experts.

“The number one reason is ... it speaks highly of management to have these policies,” explains Dick Ranaghan, former Portland city finance director and now a senior vice president for government banking at TD Banknorth. “It’s just good sound business practice. I don’t think it’s to protect your back side, although that is an outcome. Really, it’s because it makes good sense.”

Financial policies are to money management what charters are to the governing process and what comprehensive plans are to land use. They provide overall direction and prescribe the parameters within which decisions can be made with confidence they won’t be constantly second-guessed.

“They establish some level or responsibility, not only for employees but also elected officials,” says Heather Hunter, deputy finance director for Lewiston. “They’re a measurement tool. I don’t view them as a disciplinary standard, but it lets everyone know what the basis of everything is. It allows the council to think of the big picture.”

There are four basic financial policies. One to govern investments, others to determine debt level, cash flow, and purchasing practices.

Fewer than 10-15 percent of Maine municipalities have adopted formal financial policies, according to Ranaghan. They tend to be the largest cities and towns, although the need for policies may be just as great in smaller communities.

The impetus for adopting financial policies often comes when a community needs to go to the bond market to borrow funds for a large construction project such as a school building. The bond rating agencies, who determine the interest rate that a community will pay, look at a variety of factors including the size of debt, the financial condition of the community, the overall economy, the management strength of the administration and the legal structure, says Joseph Cuetara, bond counsel at Moors & Cabot in Boston.

Communities that follow written financial policies send strongly positive messages to the bond rating agencies, says Cuetara. Kennebunk, Ellsworth, Brewer, Bar Harbor and Windham all saw improvements in their bond ratings as a result of adopting formal policies, he said. Sometimes, the benefits are almost immediate. “Kennebunk adopted policies a week before the rating review process and it was a component in getting its bond rating upgraded from double A minus to double A,” Cuetara said. Freeport and Yarmouth saw their ratings upgraded after Cuetara brought to the attention of bond rating agencies the policies that had been on the books for several years, he said. “These policies led to direct rating upgrades.”

Opinion Divided

Opinion is divided over which policies are the most important. Several municipal finance people gave different answers when asked which policy they would adopt first.

“I would do a fund balance policy first,” said Lisa Parker, finance director in Saco. “It affects so many other things. It affects your bond rating, so you’re interest rate and ultimately how much it costs taxpayers.”

In Lewiston, Deputy Finance Director Heather Hunter said, “I would think overall, a purchasing policy is a critical one.”

Joseph Cuetara says he considers the fund balance and the investment policy to be the priorities. “You really have to have those,” he said. Not having a fund balance policy “can cost you.”

Fund Balance

The fund balance policy is perhaps the most controversial of the lot. The undesignated fund balance, or surplus, is money a municipality can use to even out the swings in revenues and expenditures, to deal with emergencies, and to pay other unanticipated expenses. The rule of thumb is that at least a month’s worth of tax revenue should be set aside. Ranaghan at TD Banknorth said he likes to see two months of revenue in a fund balance.

“Let’s say you’re a town of 5,000 to 6,000 people with a paper company paying fifty percent of the taxes. If the paper company doesn’t make the tax payment on time or challenges the tax valuation, you better have something in your fund balance. Let’s say you collected 90-95 percent of taxes, but now unemployment is 8 to 10 percent and you’re collecting 80-85 percent of the taxes, you better have something in your fund balance,” says Ranaghan.

In general, larger fund balances are necessary in small towns without diverse tax bases – the smaller the town, the less diverse the tax base, the less flexibility

Fund balance money is spent infrequently, except that many municipalities appropriate from “surplus” as part of the annual budget process in order to keep property taxes down. It probably is a misnomer to call these funds “surplus money” because these funds are sometimes necessary to ensure that bills are paid on time, say municipal finance professionals.

Cuetara says a fund balance policy “tastes bad, but is good for you.”

“It’s politically difficult to do,” he acknowledges. Cuetara says he doesn’t mind being the “bad guy” if it helps persuade policymakers to adopt a fund balance policy.

Purchasing Policy

A purchasing policy shows good management and also “levels the playing field” among departments, says Cuetara. Typical components include provisions for addressing potential conflicts of interest and dollar thresholds for purchase orders, solicitation of quotes and a formal bid process. It eliminates perceptions of favoritism, that a particular department head “always gets what he wants and I never do,” says Cuetara.

Saco’s 31-page purchasing policy is particularly comprehensive.

In most communities, major purchases are budgeted, sent out to bid and authorized by elected officials. Saco eliminates the council’s involvement in final authorization so long as procedures are followed. “It’s quicker and more efficient,” says Parker. “If the council has budgeted $20,000 for a mower and the lowest bid comes in at $17,000, does it need to go back to the council for approval if the council has already approved the bid specs and the budget?”

Lewiston recently adopted a policy governing use of city-issued purchasing cards. Issued to 65 city employees, the cards are supposed to eliminate unnecessary paperwork for small purchases. “The cost savings come when we don’t have to issue purchase orders for one-time vendors,” explains Heather Hunter, Lewiston’s deputy finance director. Checks, invoices and bank reconciliation statements all contribute to administrative overhead, she said. Use of credit cards also enables the city to obtain a cheaper price from a national vendor than a local store, she said. About $30,000 worth of purchases a month are made by purchasing cards, which is less than ten percent of overall city expenditures, she said. “It’s not as high as I had hoped,” she said. The cards do not eliminate the need for issuing checks for construction projects, but have eliminated the need for petty cash in every department.

Capital Reserve Policy

Freeport has avoided borrowing for some major purchases by having an aggressive policy of setting aside funds for capital projects. It helps that the town receives $170,000 a year by renting out water towers for cell phone antennas and receives $350,000 a year by renting out the former Bartol Library to Abercrombie & Fitch. In the past three years, the town has bought an ambulance, dump truck and undertaken large road maintenance projects. Other towns have capital reserve accounts to replace ambulances, but “I don’t think any have the level of funding we do,” said Freeport Finance Director Greg L’Heureux.

Investment Policy

An investment policy, among other things, determines the level of risk a community is willing to run in salting away revenues for later use. There are huge swings in both revenue coming in to town coffers and the rate bills come due.

Investing taxpayers money should follow a hierarchy of priorities: safety first, followed by liquidity, and lastly yield. In practice, that means never putting operating funds at risk, said Ranaghan. “They should be in CDs, money market accounts, interest bearing checking accounts. The funds should be guaranteed or collateralized,” he said. “You’re dealing with taxpayers’ money. You have to be very conservative.” As long as the town’s operating funds are sheltered from risk, it’s okay to take on some risk in the investment strategy for scholarship funds, cemetery perpetual care funds, and other endowments, experts say.

For example, Brunswick’s aggressive investment policy for its pool of scholarship money has seen the overall pool grow from $400,000 to $940,000 in just ten years, says Finance Director John Eldridge. “We put 60 percent in [stocks] and 40 percent in bonds,” said Eldridge. “It’s more on the aggressive side. We made a conscious decision,” he said. “Of course when the stock market took a down turn in 2000 we didn’t do well, but it’s since recovered.”

Debt Policy

Debt policy is one of the trickiest to nail down. State law prohibits communities from assuming a debt burden larger than 15 percent of the community’s total state equalized valuation. But most consider that ceiling so ludicrously high as to provide no guidance at all.

There are many ways to measure debt burden and no agreement on how much debt is appropriate.

“People always ask how much debt is too much. I say it’s too much if the day after it’s passed, they start a tax cap petition,” said Cuetara. In other words, the capacity to shoulder debt varies according to variables not well understood.

One common benchmark is to measure debt on a per capita basis. Generally, $1,500 to $2,000 per capita is considered a good goal. But not always, says Cuetara. “If you’re an affluent community, you can probably handle $4,000 per capita. Cape Elizabeth or Famouth could probably handle that. Whereas, for a small community like Hartland, that would be too much.”

Cuetara considers per capita debt measures to be “useless.”

More reliable would be pegging debt level to less than four percent of equalized state valuation or 8-10 percent of the town’s operating budget, he said. “I’ve seen it as high as 25 percent, but the lower the better,” said Ranaghan. “It depends on lots of things. You have to go on a case-by-case basis.”

Back in the 1990s, Orono thought it could shoulder a relatively high tax burden to attract a high-tech company. That because the town’s unusually well-educated, high-turnover work-force is an ideal match for a high tech company, even though the town’s tax base is relatively small from having so much untaxed property occupied by the University of Maine. So the town floated an $8 million bond to lure EnvisionNet, a computer technical support company, even though the burden represented more than six percent of state equalized valuation. The town’s gamble didn’t pay off. EnvisionNet went out of business in 2001, leaving the town holding the bag. By contrast, Auburn has taken on more debt than some would consider prudent and it has not hurt the community, says Cuetara. Auburn’s debt is now 11.9 percent of its operating budget, higher than the 8 to 10 percent benchmark. But Auburn is paying off the debt on an accelerated schedule, which lessens the risk, he said. “Over 75 percent of the debt will be paid off in 10 years. Okay, that’s fine.”

Small Towns and Financial Policies

Skeptics in small communities might be forgiven for wondering if formal policies are necessary for them. Do they really need, for example, a 31-page purchasing policy?

Well, conflicts of interest may be more pronounced at the local level. Let’s say the newly elected selectman owns an excavating business and promises to save the town money on its snow plowing contract. How do you give him a fair shot at the contract without showing favoritism? A purchasing policy can establish procedures to handle the situation with a minimum of fuss. Small towns also have fewer professional staff and because many of them are elected officials, the rate of turnover is often higher.

“In a small town, you might see the treasurer turn over every year. I don’t mean that in a derogatory sense,” said Lisa Parker in Saco. “But certainly someone who’s been in office for five or ten years and may have a CPA, a degree in acounting, will have a better handle on risk in every move that is made than a new treasurer, just elected, who might not have the background or education.”

When asked if policies are as important to small towns as larger communities, Parker said, “Certainly, I would think it is more important for smaller towns. “It’s important to cover themselves. Then, citizens or elected officials can’t come back and point fingers if you’re following the guidelines.”

But in small towns, the more active involvement of voters may lessen the need for formal policies needed by larger communities , suggests Veazie Town Manager Reed. In some cases, financial policies are approximations of the will of voters. If debt is voted on in a town-wide referendum, perhaps a debt policy is unnecessary, he says.

“A referendum is the real guide,” said Reed. “Even if the [total debt] number is high, if that’s something the community wants, they will pay for it.” Reed said Veazie’s school bond passed “so overwhelmingly” that the community probably would have supported the debt even if it was much higher.