THE SURPLUS DEBATE: To dip or not to dip
(from Maine Townsman, January 1999)
By Jo Josephson, Staff Writer

Surplus is a term that gets bandied about quite a bit this time of year as local officials prepare municipal budgets. Typically, discussions regarding surplus lead to the following questions: Shall we dip into the surplus this year? How much should we leave in surplus? How should we spend surplus?

This article attempts to address such questions by looking at what the Government Finance Officers Association (GFOA) has to say about surplus, as well as how a number of municipalities around the state manage it.

In doing so, it looks at the written policy that the City of Bangor recently developed regarding its use of surplus; it also looks at a number of unwritten policies that are currently guiding other municipalities as they attempt to manage their surplus.

For without a policy, written or unwritten, you could find your surplus being raided and reduced to dangerously low levels, as was the case last year in Millinocket and Biddeford, where the reductions made headlines.

Before looking at the literature, policies and practices, the article focuses on the term "surplus," which, some say, is at the root of its misuse or abuse.

SURPLUS: THE DEFINITION

Look at your audit; you will not find the term "surplus." Look at the literature on municipal finance; you will not find the term "surplus". As Bar Harbor Town Manager Dana Reed points out, use of the term " surplus" is generally discouraged by the Government Finance Officers Association (GFOA), because, to quote from GFOA’s glossary of financial terms, use of the term "creates a potential for misleading inference." Misleading one to view surplus as extra money or money that you don’t need, says Reed. Which, in many cases, simply is not true.

The proper terminology

What then is the proper term to use when you are talking about so-called surplus monies? The GFOA glossary refers to the term "Fund Balance," which is the difference between a municipality’s assets and its liabilities, or its equity.

But there are different types of fund balances. There is the type that is designated or reserved, and there is the type that is undesignated or unreserved. It is the latter type,the undesignated/unreserved fund balance – what you have left after you have subtracted your general fund liabilities and reserve funds from your assets – that municipal officials usually, but not always, refer to when they talk about dipping into surplus.

IMPORTANCE OF SURPLUS

The undesignated fund balance, a.k.a surplus, is to be used as a means of maintaining "fiscal stability," as a "hedge against economic uncertainty", states GFOA’s Ian Allen in his paper, Unreserved Fund Balance and Local Government Finance. Fiscal stability is not only critical for meeting the payroll and maintaining services, says Allen, it is also critical when it comes to one’s credit rating. Banks want to know if you will be able to pay back the loan, and how good a risk you are. In other words, how stable are your finances?

Arguments for

Those who drafted Bangor’s policy regarding the management of its fund balance appear to agree with Allen. A reading of the policy indicates that while the undesignated fund balance serves a number of "stabilizing purposes" it should "not be used to fund any portion of its on-going and routine year-to-year operating expenditures."

Rather, the undesignated fund balance represents a "savings account" or "rainy day fund" which is available for "unforeseen emergencies". It also provides a "cash flow cushion" to offset the need for borrowing in anticipation of tax receipts. And, last but not least, it provides evidence to the city’s bond holders and bond rating agencies of financial stability and credit worthiness.

Arguments against

Bangor aside, GFOA’s Allen notes that not everyone, especially taxpayer groups in times of economic downturns, agrees with his view. He writes that there are those who see surplus as monies that are being "hoarded", monies that rightfully belong to the taxpayers. They believe that when the money is needed, it will be raised, and until then surplus monies should be returned to the taxpayers in the form of reduced taxes.

That kind of attitude could be reined in if there were a fund balance policy in place. According to Allen, "An important reason for developing such a policy is to provide the taxpayers with an explanation of why financial resources have been set aside and the conditions under which such resources will be expended."

That kind of attitude is what causes some municipalities to move their monies into dedicated reserve accounts as a means of protecting, or sheltering, them.

That kind of attitude was in part what caused Biddeford to run down its undesignated fund balance from $5.4 million (16 percent of its annual budget in 1995) to $2.7 million (3.8 percent in 1998), in order to keep the tax rate stable at $17.50 per thousand.

Which leads to the question: How deep into surplus shall we dip? Which might best be reframed by asking: Is there a sufficient amount of surplus, too much, or too little?

HOW MUCH IS ENOUGH?

"Determining the appropriate size of the unreserved fund balance is one of the more formidable tasks facing local government finance officers and elected officials," says GFOA’s Allen. What is good for one municipality, given its particular financial and economic character, may not be good for another.

Some rules of thumb

As Allen points out in his article, a municipality facing a high degree of uncertainty, such as one dependent on one or two major revenue sources or one with uneven cash flows, would want a higher than average amount in its undesignated fund balance, as would a municipality with a policy against borrowing in anticipation of taxes, or a smaller community where unforeseen circumstances would have a higher impact on its budget.

However, a municipality with a deep and broad tax base, or one with resources in so-called credit reserve funds or budget stabilization accounts or contingency accounts, may be able to function with a smaller undesig-nated fund balance.

Lewiston Finance Director Richard Metivier advises, "Each municipality should take into account its exposure to financial uncertainty and act accordingly in terms of the level it sets for its fund balance."

Be that as it may, there are certain numerical rules of thumb to guide you. They are either based on a certain percentage of your annual operating expenditures or on a certain number of months of your operating expenditure, providing you with sufficient cash flow to meet payrolls, emergencies and the like in the name of stability.

Allen reports that credit rating institutions like to see an unreserved fund balance or other resources available for contingencies at about five percent of the annual operating expenditures. But they might go higher or lower. It depends.

Credit rating agencies aside, Allen reports that another widely used standard sets sufficiency at one month’s operating expenditures, or 8.3 percent of the annual operating expenditures. However, he adds that two to three months is not uncommon but that any municipality with more than 10 percent should be prepared to justify the level. For some, the justification could be the volatility of the tax revenue, such as a major taxpayer seeking abatements or a higher than usual level of tax liens.

In practice

So how do these standards play out locally here in Maine? Numbers reported in MMA’s 1997 Local Government Fiscal Survey indicate a wide range of percentages, from as low as 1.5 percent in Temple, to 7.8 percent in Cape Elizabeth, to 10.1 percent in Waterville, to 12 percent in Jay, to 15.6 percent in Kittery, to 17.8 percent in Fort Kent, to 24 percent in Lamoine, to 44 percent in Carrabassett Valley.

Forty-four percent? The justification for the high level in Carrabassett Valley is that by keeping such a high amount in surplus the town does not have to borrow in anticipation of taxes, explains Town Manager William Gilmore. He also notes that Carrabassett dips regularly to the tune of $150,000 to $170,000 a year to reduce the tax commitment.

At a mill rate of $6/$1,000 of valuation, the 345 residents of the town are not complaining about the high level of surplus, says Gilmore. As reported in MMA’s 1997 Fiscal Survey, Carrabassett Valley, the home of Sugarloaf USA, has an unallocated fund balance of $705,000 and a budget of about $1.6 million.

Written policy

Turning again to Bangor one finds not only a written policy, but an article in its charter targeting the sufficiency of its fund balance. The charter establishes a range of no higher than 10 percent of the operating budget, excluding debt service, and no lower than 5 percent. The policy specifically targets an undesignated fund balance approximating 7.5 percent of operating expenditures (less debt service).

For example, in FY 95, Bangor’s general fund expenditures (gross) totaled $55,530,634; its general fund debt service totaled $3,444,057, leaving a net of $52,086,577; its undesig-nated fund balance totaled $4,081,936.

Under Bangor’s 7.5 percent target that meant there was a surplus of $175,443 in the undesignated fund balance, or a "surplus in the surplus". Under Bangor’s policy those monies are to be used to fund and increase the city’s various reserve accounts that make up its designated fund balance as well as its appropriated contingency account.

MANAGING SURPLUS

Definitions and rules of thumb aside, cities and towns around the state have each developed their own unique approach to managing and using their surplus, as the following descriptions indicate.

Wells: Demonstrate an "active" surplus account

Currently there is a $3.5 million undesignated fund balance in Wells, which Town Manager Jonathan Carter, calls "unappropriated surplus." Carter says $2 million, the equivalent of two months operating expenses, is "set to one side"; the rest is "luxury", which the town can either spend, "expose" to spending, but not necessarily spend, or move to a designated reserve account.

As Carter describes it, Wells is a pay-as-you-go town. So it is not surprising that town officials work hard to demonstrate to taxpayers that there is an "active" surplus account. Which is to say, town officials take pains each year through means of a worksheet to spell out the plans for using that surplus.

According to the worksheet, in FY 99, $290,000 of unappropriated surplus was budgeted to reduce the town’s tax rate; $178,000 was "exposed" to various potential uses, such as legal services; and $395,000 was moved to a newly established capital improvement projects reserve fund.

As Carter explains, managing surplus in a municipality with a pay-as-you-go philosophy means that you make people feel good about using surplus, but not necessarily expending it. Like other managers interviewed for this article, Carter says "managing surplus is an art; it’s like walking a tightrope."

Bar Harbor: Designate surplus

Town Manager Dana Reed explains that there is an unwritten policy in Bar Harbor to create designated reserve funds with surplus monies in order to emphasize that the surplus is not really surplus. "By creating designations, it tells the world why you need the money," Reed says.

For example, where other municipalities use their undesignated fund balance for working capital (read, cash flow), Bar Harbor has created a designated fund for that purpose.

In FY 97, $1,028,000 of the general fund balance was reserved or designated for "working capital", an amount equivalent to three-months operating expenses. "Setting this much aside fits in with the town’s unwritten policy of avoiding borrowing in anticipation of taxes," explains Reed.

Bar Harbor has also instituted an aggressive capital improvement program. In FY 97, it had approximately $567,000 in a capital improvement program reserve fund.

While this approach indicates there is a plan for the surplus monies, it is not one that ties up the money in the short run, explains Reed, noting that anything technically designated by the council can be changed by the council at any time.

Biddeford: Don’t misstate your fund balance

As noted above, in 1995 Biddeford reportedly had $5.4 million in surplus, which amounted to slightly more than 16 percent of its annual budget.

"It looked like we had a lot more surplus than we actually did," Biddeford City Manager Bruce Benway told the TOWNSMAN, "due to the fact that we were not covering all of our liabilities, like $1.5 million in accrued summer wages of our teachers." In other words, says Benway, "We were misstating our fund balance; we had unfunded liabilities; if a credit agency had come in and done the arithmetic, they would have seen we only had $3.9 million in surplus."

Benway notes that moving $300,000 a year out of surplus over the five-year period to cover the accrued wages was part of the reason for the drop in surplus to $2.7 million or 3.8 percent of the annual budget in 1998. But it wasn’t the only reason. The other was the mayor’s view that surplus should be returned to the people by keeping the tax rate stable at $17.50 per $1,000 of valuation.

Benway says such things happen because the balance sheet in most municipalities is managed quietly. "There is no open public debate; there are a limited number of players; people are afraid to argue for a strong balance sheet because it will look like we have large amounts of cash lying around, which we don’t," says Benway. "The challenge," says Benway, "is to open the door on its management and build an appropriate balance sheet that reflects the corporate entity that we are."

That said, Benway reports that Biddeford is currently drafting an ordinance (not a policy), based on Bangor’s policy, to spell out, among other things, a minimum level for its undesignated fund balance, a minimum level that will enable the city to meet its obligations. Benway anticipates that the city will achieve a 7.5 percent (of operating budget) surplus in three years.

Kittery: If you dip deeply, rebuild quickly

According to the MMA Fiscal Report, in 1997 Kittery had $2.5 million in its undesignated fund balance. Given a $16 million operating budget, the $2.5 million represent about 16 percent of the budget or two months operating expenses.

It’s a far cry from the $69,000 undesignated fund balance that Town Manager Phil McCarthy found in the town’s coffers when he was hired 10 years ago. But it is an amount he is willing to risk drawing down, temporarily, under certain circumstances, as he did last year to pay for a new $3.4 million town office when a referendum regarding a proposed $1.8 million bond issue for the project lost by a slim margin.

While there was only $1.5 million set aside in a special reserve account for the project, there was an additional $2.9 in the town’s undesignated fund balance to draw upon. Realizing the risk they were taking, the council voted to withdraw $1.9 million from the undesignated fund balance, leaving only $1 million in surplus, a number far below the town’s targeted threshold.

But as McCarthy explains, "We looked at our projected cash flow needs. Our risk was that we might have to take out a Tax Anticipation Note (TAN). Our other risk was that if we waited to go to referendum again, the cost of the project would have risen. We figured that by using surplus we would save over $800,000 in interest over the life of the bond; the cost of a TAN was significantly below that at $100,000 a year."

McCarthy reports that a year later, surplus was back up to $2 million. The increase came as a result of a number of things including the standard practice of budgeting conservatively on revenues, like excise tax, and cautiously on expenditures, and the auditor’s suggestion that the town fold in about $500,000 from dedicated accounts that had not been used for years.

Presque Isle: Engage in a healthy discussion

Currently, the unwritten policy in Presque Isle is to keep between $1.2 and $1.9 million in surplus. Currently, there is a $1.8 million surplus. With an operating budget of $7.5 million, Presque Isle’s undesignated fund balance stands at about 24 percent, an amount City Manager Tom Stevens says is sufficient to cover three month’s operating expenses. Stevens notes that the level is needed because of the slow cash flow and high rate of tax liens in the city.

Stevens also notes that the use of surplus in Presque Isle always provokes a "healthy discussion" among the council members. At any given time, there are those with what he calls the short view, who want to dip into surplus to keep the tax rate stable, and those with what he calls the long view, who do not want to dip into surplus so they do not have to borrow in anticipation of taxes.

The current practice appears to encompass a bit of both views. In 1998, the council took $300,000 from surplus to offset the tax rate ($332,000 equals one mill); it also took out a Tax Anticipation Note. But it was only half of what it used to be, points out Stevens, adding that while there is nothing wrong with borrowing, too large a surplus means we are overtaxing the residents.

As Stevens sees it, "There are no right answers; it’s whatever the council is comfortable with."

 Resources

• Designated and Undesignated Fund Balance Policy, City of Bangor. 10 page document. Contact Jo Josephson at the MMA 1-800-452-8786.

• Unreserved Fund Balance and Local Government Finance, Ian Allen, Research Bulletin, Government Finance Research Center, 1750 K Street, N.W. Washington DC 20006 (202) 429-2750

• An Elected Officials Guide to Fund Balance, Stephen J. Gauthier. Government Finance Officers Association, 180 No. Michigan Ave., Suite 800, Chicago, IL 60601