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RPVCCA_CC_SR_2012_06_05_07_City's_Reserve_PolicyCITY OF MEMORANDUM RANCHO PALOS VERDES TO: FROM: DATE: SUBJECT: REVIEWED: Staff Coordinator: HONORABLE MAYOR AND MEMBERS OF THE CITY COUNCI~ DENNIS McLEAN,DIRECTOR OF FINANCE &INFORMATION TECHNOLOGY JUNE 5,2012 CITY'S RESERVE POLICY (Supports 2012 City Council Goal of City Reserve Policy),..il CAROLYN LEHR,CITY MANAGER U>L--- Kathryn Downs,Deputy Director of Finance &Information Technology RECOMMENDATION 1.Receive and file the Finance Advisory Committee's Memorandum to City Council dated May 23,2012,and the updated Fiscal Risk Analysis outlined herein;and 2.Make no changes to the City's Reserve Policy at this time. EXECUTIVE SUMMARY On March 20,2012,the City Council made the following assignment to the Finance Advisory Committee (FAC). "Directed the Finance Advisory Committee to review and discuss the Reserve Policy at the level of 55%of General Fund operating expenses compared to the current level of 50%of General Fund operating expenses and provide feedback regarding the Reserve Policy to the City Council." During the City Council's discussion on March 20th ,Mayor Misetich explained that the reasoning for a potential increased Reserve Policy is based on pending capital improvement projects and potential future state actions that may impact the City's revenues. On April 25,2012 and May.23,2012,the Finance Advisory Committee (FAC)reviewed the City's Reserve Policy.The FAC prepared a memorandum to'City Council dated May 23, 2012 (see Attachment A)that summarizes observations and recommendations to the City Council.The FAC recommends maintaining the current policy of 50%of General Fund 7-1 CITY'S RESERVE POLICY June 5,2012 Page 2 of 9 expenditures,citing that this is a minimum level and does not preclude maintaining the General Fund Reserve in excess of the policy threshold. In preparation for the FAC's review of the Reserve Policy,Staff updated the Fiscal Risk Analysis which has not significantly changed from 2010.Staff has also updated benchmarking information from 13 other cities,which appears to indicate that the City's policy continues to be one of the most conservative. The Capital Improvement Projects Reserve (for both known and unknown future projects) continues to grow by amounts equal to transient occupancy tax revenue each year,and is available for unfunded projects.The draft 2012 CIP includes at least $50 million of unfunded projects identified.Proposition 1A established by California voters in 2006 and Proposition 22 established by California voters in 2010 have restricted the State's ability to raid local government revenue.With the phase-out of vehicle license fees in 2011,the City's General Fund no longer receives state-shared revenue. BACKGROUND History Prior to 2008,the City Council had an informal reserve policy of 50%of General Fund revenues.On December 2,2008,the City Council formalized its policy by adopting City Council Policy No.41 -Reserve Policies (Reserve Policy),which included a rainy-day fund of 50%of General Fund expenditures and a minimum $3 million Capital Improvement Projects (CIP)Reserve.The 50%General Fund reserve level was based on an analysis that included the City's risk factors,timing of significant revenue source cash payments, and historical needs.Benchmarking with other cities indicated that the 50%threshold was very conservative. On December 21,2010,the City Council modified the policy to provide a funding mechanism for the CIP Reserve,which was to transfer General Fund amounts equal to Transient Occupancy Tax (TOT)revenue.This funding mechanism was established to provide for future CIP projects approved by the City Council that have either insufficient or no restricted funding.The goal is to provide a dedicated funding source for CIP projects, segregating TOT revenue from operations in the General Fund. On April 19,2011,the City Council further modified the policy to comply with new accounting standards and definitions for funds used by the City.No changes were made to reserve policy thresholds in 2010 and 2011. Finance Advisory Committee Recommendation After the FAC reviewed the City's Reserve Policy,it prepared a memorandum to City Council dated May 23,2012 (see Attachment A)that summarizes observations and recommendations to the City Council.The FAC recommends maintaining the current policy of 50%of General Fund expenditures,citing that this is a minimum level and does not preclude maintaining the General Fund Reserve in excess of the policy threshold. 7-2 CITY'S RESERVE POLICY June 5,2012 Page 3 of 9 DISCUSSION The City has a total FY11-12 revenue budget of about $35.5 million,which includes $23.6 million of General Fund revenue sources that can be used for any purpose.The remaining revenue is restricted by law for specific uses.The City's Reserve Policy (see Attachment B),and the estimated status as of June 30,2013 based on the draft FY12-13 budget is summarized in the following chart. General Fund 50%of budgeted expenditures 9,597,810 11,055,379 1,457,569 One year of Portuguese Bend Street Maintenance road maintenance 526,400 611,234 84,834 Habitat Restoration Emergency projects 50,000 50,000 Habitat Restoration Future maintenance 85,125 135,488 50,363 Subregion One Developer endowment 750,000 758,607 8,607 Capital Improvement Projects Emergency or Future Projects 3,000,000 11,106,362 8,106,362 Capital Improvement FEMA reserve for FY04-05 Projects winter storms 215,209 215,209 Equipment Estimated replacement cost of Replacement assets held 1,833,141 1,750,919 (82,222) Ten-Year History of Actual Reserves vs.Policy Levels In millions $16 $14 $12 $10 $8 $6 $4 $2 $- FY02-03 FY03-04 FY04-05 FY05-06 FY06-07 FY07-08 FY08-09 FY09-10 FY10-11 FY11-12 ActUal Reserve Level -Policy Threshold In FY08-09,the informal policy of 50%of General Fund revenue was changed to a formal policy of 50%of General Fund expenditures. 7-3 CITY'S RESERVE POLICY June 5,2012 Page 4 of 9 Best Practices Standard &Poor's has developed criteria for financial management of governments (see Attachment C).This publication includes criteria for reserve and liquidity policies (begins on page 5 of the document).At the California Society of Municipal Finance Officers conference on March 1,2012,Gabe Petek,Senior Director of U.S.Public Finance at Standard &Poor's,indicated that any changes to financial management policies should be clearly documented,including the reasons for the change and criteria for future changes. The City has not established a municipal bond rating at this time.Based upon discussions with the City's financial advisor and municipal finance peers,Staff understands that any subsequent changes to the City's reserve policy thresholds should be considered cautiously based upon the results of a Fiscal Risk Analysis in combination with a significant change of circumstances.Staff understands that bond raters consider the City's establishment and adherence to a prudent reserve policy during its rating process. The Government Finance Officers'Association has developed a best practice recommendation for reserve policies (see Attachment D),which recommends that governments should maintain unrestricted fund balance in their General Fund of no less than 2 months of regular General Fund operating revenues or expenditures. Benchmarking One method to use when determining where the City's reserve policy should be positioned is to consider reserve policies from comparable cities.By tracking reserve policies from comparable cities,we can determine the current economic climate by noticing any shifts in overall reserve policy patterns and if the City's current reserve policy is adequate in addressing the ongoing risks relevant to the City.As seen below,the City of Rancho Palos Verdes continues to hold one of the most conservative reserve policies. Table of Reserve Policies from Comparable Cities Dana Point Cash Flow Reserve 10%of General Fund Revenue Emer enc Reserve 20%of General Fund Revenue Capital Projects Sinkin Fund Minimum balance of $2.5 million Calabasas Hermosa Beach La Canada/Flintrid e La una Hills Los Altos Manhattan Beach Malibu Palos Verdes Estates Redondo Beach State Budget 1m acts Fund General Fund General Fund General Fund General Fund General Fund General Fund General Fund General Fund General Fund 7-4 CITY'S RESERVE POLICY June 5,2012 Page 5 of 9 100%of prior year's adopted budget Rolling Hills General Fund expenditures Community Unrestricted fund balance of 100%of budgeted Facilities Fund annual expenditures 100%of the City's California Joint Powers Municipal Self Insurance Authority liability insurance costs over Insurance Fund a rolling 5 year period Minimum cash &investments equal to 100%of the latest 30 year actuarial estimate in the CalPERS California Employer's Retirement OPEB Fund Benefit Trust Unrestricted fund balance of 100%of budgeted Utility Fund annual expenditures Rolling Hills Estates General Fund Minimum balance of $1.2 million Saratoga'General Fund Minimum balance of $2 million Development Funded with excess development end-of-year Services Fund balances Environmental Services Funded with Refuse surcharqe fees Economic Uncertainty Fund Minimum balance of $1.5 million 2012 Fiscal Risk Analysis Since the Fiscal Risk Analysis was last completed in 2010,the state discontinued paying the City about $0.2 million of annual vehicle license fee revenue;however,the City's revenues (inclUding property tax)continued to increase throughout the recession.Except forthe storm drain userfee that sunsets in 2016,Staff is unaware of any material losses of revenue in the near term.An updated version of the Fiscal Risk Analysis follows.Overall, there appears to be no significant changes to the City's fiscal risk since the 2010 Analysis was performed. Revenue Volatility In General,the City does not face significant revenue volatility risk due to the City's large dependence on property tax revenues ($10.6 million or about 44%of annual General Fund revenue)and the City's strong property tax base.The average property assessment in the City is about $0.75 million per parcel,which continues to be considerably less than current market values.When even a small number of properties transfer ownership each year resulting in a reassessment and the remaining property assessments continue to increase pursuant to Proposition 13,an overall decrease of the City's total property tax revenue is a highly improbable event. Unlike other California cities that experienced significant revenue declines as a result of the economic downturn that began in 2008,the City's General Fund revenue stream remained stable.Community Development permit revenue ($1.8 million or about 7%of General Fund revenue)is certainly more affected by the economy and can be more volatile. Through the recent recession,Community Development permit revenue remained relatively flat.The proposed FY12-13 budget is $1,774,000,which is almost exactly the 7-5 CITY'S RESERVE POLICY June 5,2012 Page 6 of 9 amount of revenue received for FY07 -08. Sales tax ($1.6 million or about 7%of General Fund revenue)is also affected by the economy;however,due to the limited commercial property in the City,there is little reliance on sales tax when compared to other California cities.Primarily due to the Terranea Resort restaurants,sales tax has actually grown by 46%since FY07-08. Although the City's TOT is expected to be about $3.2 million or 13%of General Fund revenue and is dependent upon a potentially volatile hotel industry,it serves as a funding source for capital projects and does not fund the City's operating budget. Cash flow is another factor that can impact revenue volatility.In Staff's analysis of the City's cash flow,it proved to be an insignificant risk due to the steady and predictable trend.The only spikes in the fiscal year reflect the two large collections of property tax revenues in December and April. Another variable to consider in examining revenue volatility is the stability of revenue receipts from the state,especially in light of continued State budget issues.The State of California has a history of taking revenues from local governments to resolve the State's budget problems.However Proposition 1A established by California voters in 2006 and Proposition 22 established by California voters in 2010 have restricted the State's ability to raid local government revenue.With the phase-out of vehicle license fees in 2011,the City's General Fund no longer receives any state-shared revenue.As with the Governor's January version of the FY12-13 budget,other than issues associated with redevelopment dissolution,the May Revision contains no proposed shifts using city funds.There is no proposed shift of local shares of Highway User's Taxes (HUTA). Ten-Year History of General Fund Revenue In millions $25 $20 $15 $10 t-__T $- FY02-03 FY03-04 FY04-05 FY05-06 FY06-07 FY07-08 FY08-09 FY09-10 FY10-11 FY11-12 FY06-07 General Fund revenue included a one-time receipt of about $0.9 million for unusable Proposition A revenue sold to another agency.In FY07-08,there were significant decreases of interest earnings and building permit revenue. 7-6 CITY'S RESERVE POLICY June 5,2012 Page 7 of 9 Uninsured Losses These risks from potential uninsured losses are best estimated through a complete actuarial analysis,which can be very costly to perform.Insurance deductibles and co- insurance terms were evaluated by staff and showed to be immaterial.The deductibles range from $1,000 for city-owned vehicle losses to a maximum of$100,000 for earthquake and flood damages.As noted in the City's financial statements,during the prior three fiscal claim years,no settlements or judgments have exceeded pooled or insured coverage. Liability risks not normally covered by insurance,such as labor relations issues should also be given some consideration in evaluating the City's reserve level. Over the last decade,the City has been a defendant in several significant lawsuits resulting from challenges by property owners regarding regulatory decisions,including view,antenna and other:land use issues.Insurance loss protection would not have been available in the event significant monetary damages were awarded by trial courts.Several lawsuits were the result of City ordinances that have been enacted by voters and/or the City Council and facts and circumstances that may continue to be challenged by property owners.The possibility of uninsured future trial court awards should continue to be considered during the assessment of the City's reserve policy. Environmental and Regulatory Risks Rancho Palos Verdes'physical characteristics create a substantial risk to the environment due to the City's aged infrastructure,land movement,and changing environmental regulations and penalty provisions.With 7.5 miles of coastline,the City carries a significant risk for polluting the shoreline and the ocean in the event that a sewer line or storm-drain system fails.Environmental fines can cost at least $10,000 per day for these types of events.Other cities have faced significant fines;and typically these are settled for an agreed upon amount,but they can still be very costly.The City should strongly consider this risk in the development of the reserve policy. Disaster and Terrorism Risks Many costs of declared disasters are covered by state and federal funds;but there is still a portion of the cost that is not,and the receipt of state and federal funds may not be immediately available.The City faces risk from fire,earthquakes,flood,landslide,and terrorist threats at the Port of Los Angeles;and it is critical that reserves be available to respond to these events appropriately.Staff consulted with the Office of Emergency Preparedness Area G coordinator to gather information about disaster risks specific to Rancho Palos Verdes.The City's coordinator stated that there are no best practices for quantifying the potential damages.The City's portion of uncovered disaster costs would be 6.25 percent of the total amount of qualifying damages.The Federal Emergency Management Agency (FEMA)provides cash advances for disaster relief differently depending on the size of the event,and the amount would likely be immaterial.There is a high level of uncertainty in trying to determine the amount needed for upfront costs for repairs due to so many unknown variables.Additionally,federal funds for disaster assistance are subject to audit,disputes,potential negotiations and settlements.The City should consider this risk in the development of the reserve policy. 7-7 CITY'S RESERVE POLICY June 5,2012 Page 8 of 9 Capacity Maintenance and Transition Policies When permanent changes in resources or costs occur,reserves should be adequate to provide funds for a smooth transition while seeking new resources or reducing ongoing costs.A common example of this change would be the building and development activity, which is significantly impacted by the local and national economy.When the economy slows down,it is common for building activity to also slow,and this can cause a loss in revenue.For example,with the recent recession,the FY08-09 Community Development revenue decreased by $120,000.Reserves are necessary to balance any cyclical changes in activity.This risk factor is of moderate significance because these fees are only a small percentage of the City's total revenue. Infrastructure During the City's early history,financial resources were not sufficient to fund repair and maintenance of infrastructure resulting in further deterioration.Over the last decade,the City has begun to establish systems to regularly evaluate the status and need for repair and maintenance of its street,arterial roadways,sewer and storm drain infrastructure. Although the City has made significant progress improving the condition of its infrastructure systems,Staff believes that the cost of known repairs and maintenance of infrastructure exceeds the current level of net annual revenue and fund reserves.As an example,the San Ramon project was not included in the storm drain program established in 2005,and is currently estimated to cost about $19.4 million. Ten-Year History of Capital Expenditures In millions $25 $20 $15 $10~ $5~ $- FY02-03 FY03-04 FY04-05 FY05-06 FY06-07 FY07-08 FY08-09 FY09-10 FY10-11 FY11-12 FY05-06 expenditures included $17 million for purchase of the Portuguese Bend open space.The FY11-12 budget includes $7.8 million for street paving projects and $2 million for improvements at Lower Hesse Park. A portion of the FY11-12 bUdget will likely be carried forward to FY12-13.7-8 CITY'S RESERVE POLICY June 5,2012 Page 9 of 9 In developing the original reserve policy,staff looked back from a historical perspective to consider the unplanned events from the past ten years which required a large unexpected disbursement from the General fund or money from the General fund reserves.Events such as the Upper San Ramon drainage and landslide stabilization project ($4 million)in FY02-03,and the McCarrell Canyon storm drain project ($7.5 million)completed in FY08- 09 are examples of how the City's physical characteristics,aging of infrastructure,and unexpected events have cost the City millions to repair. The following is a list offuture infrastructure funding issues that should also be considered with the Fiscal Risk Analysis. ~The Storm Drain User Fee,which generates revenue totaling about $1.2 million annually,will sunset in 2016 in accordance with the ballot measure approved by the voters in 2007;at which point there will be no dedicated funding source for maintenance and repair of the City's storm drain infrastructure. ~Although the San Ramon project was awarded Proposition 1E funding from the State Department of Water Resources in the amount of $9.4 million,a funding shortfall of about $10 million still exists.The City is actively pursuing federal and local agency contributions to the project;however,a contribution from the City's reserves may become necessary. ~There are at least $50 million of other unfunded projects identified in the 2011 Five- Year Capital Improvement Plan. ~The County currently maintains the City's sewer system;but the level of maintenance may not be adequate in the future.Although the County has made repairs as necessary in the past,the City is ultimately responsible for the sewer system.The City has no funding source dedicated to sewer maintenance and repairs. ~The dedicated funding sources for arterial street projects are insufficient.The draft 2012 Five-Year Financial Model currently includes only one $2.3 million arterial street project due to the limited funding available. ~The Citywide Americans with Disabilities Act (ADA)Transition Plan has identified projects with cost estimates totaling about $6.7 million.There is currently no funding source for these projects. ATTACHMENTS A -Memorandum from Finance Advisory Committee dated May 23,2012 B -City Council Policy No.41,Reserve Policies C -Standard &Poor's Financial Management Assessment D -Government Finance Officers'Association Best Practice,Appropriate Level of Unrestricted Fund Balance in the General Fund 7-9 Attachment A MEMORANDUM To:City Council From:Finance Advisory Committee Date:May 23,2012 RE:City's Reserve Policy Background: At the March 20,2012 City Council meeting,the Council requested the Finance Advisory Committee ("FAC")to: "...review and discuss the Reserve Policy at the level of 55%of General Fund operating expenses compared to the current level of 50%of General Fund operating expenses and provide feedback regarding the Reserve Policy to the City Council" The FAC reviewed the April 25 Staff report regarding a proposed change to the City's Reserve Policy at its April 25,2012 meeting.Following the discussion,the FAC Chair formed a subcommittee to develop its recommendation to the Council (Members Stillo and de la Rosa).The FAC understands that the 50%factor was based upon semi-annual property tax receipts to the City. The FAC's recommendation to the Council is based upon: •The Staff report dated April 25,2012, •The existing City Reserve Policy,and •Its review of the GFOA guideline regarding reserve levels Recommendation: The FAC believes the present Reserve Policy,which requires a minimum reserve balance of 50%of budgeted expenditures,is adequate and recommends maintaining the present policy level.The FAC bases its recommendation on the following: •The policy states that the threshold reserve level of 50%is a "minimum". There is nothing in the policy which would preclude the Council from maintaining the general reserve in excess of the 50%policy threshold, 1 7-10 Attachment A •The existing reserve policy level exceeds the minimum recommendation of the GFOA and is adequate based upon a benchmark review of local peer agencies,and •It has been suggested by staff that frequent policy changes could signal that management's administration of policies is arbitrary and,therefore, the policies are less reliable to third parties. The FAC recommends that the basis for the City's general fund and other reserve amounts should be periodically supported through a formal risk assessment. The Staff Report dated April 25,2012 identified a variety of fiscal risks.The FAC believes the Staff should further develop the risk analysis outlined therein to assess and where appropriate,develop quantitative and qualitative risk analysis and documentation to support the level of General Fund and other reserve policies.For example,the CIP reserve amounts are supported through the City's periodic identification,assessment,quantification and prioritization of infrastructure projects. 2 7-11 Attachment B CITY COUNCIL POLICY NUMBER:41 (Amended) DATE ADOPTED/AMENDED:April 19,2011 SUBJECT:Reserve Policies POLICY: The City utilizes a variety of accounting funds for accounting and budgeting for revenues and expenditures of the City.Appropriations lapse at each fiscal year- end.'The City Council authorizes continued appropriations for certain incomplete capital projects,other one-time projects and services which have not been billed. Remaining dollars left in each fund that are undesignated and unencumbered constitute available reserves of the City.It is appropriate that reserve policies for the City be established for each of the various funds,that the purpose of these reserves be designated,and that dollars available in excess of the reserve amounts be appropriately and effectively utilized.This policy governs the City's reserves as follows: A.General Fund The City will maintain a minimum fund balance of at least 50 percent of annual operating expenditures in the General Fund.This is considered the minimum level necessary to maintain the City's credit worthiness and to adequately provide for: 1.Economic uncertainties,local disasters,and other financial hardships or downturns in the local or national economy. 2.Contingencies for unseen operating or capital needs. 3.Cash flow requirements. B.Capital Improvement Fund The City will maintain a minimum of $3 million in the Capital Improvement Projects (CIP)fund as a reserve for major improvement projects related to roadways,storm drains,parks,buildings,rights-of-way,and the sewer system.Subject to the annual budgeting process,the CIP reserve will be funded,to the extent possible,by allocating amounts equal to the annual Transient Occupancy Tax (TOT)revenue to the CIP fund.All interest earnings in this fund will be used for capital improvement projects. C.Equipment Replacement Fund The City will maintain retained earnings equal to the estimated replacement cost for equipment assets held by this fund. 1 7-12 City Council Policy #41 (Amended) D.Water Quality Flood Protection Fund Project spending in the Water Quality Flood Protection (WQFP)fund fluctuates year to year.The Storm Drain User Fee is a source of funding for these projects.To avoid a fluctuating Fee,the City will maintain retained earnings over the life of the WQFP fee to establish rate stabilization,thereby enabling fund availability for scheduled projects and maintenance. E.Building Replacement Fund The City will maintain retained earnings in this fund to accumulate monies and interest earnings to finance major improvements (e.g.roofing),and partially provide for future replacement of City owned buildings. F.Utility Undergrounding Fund .The City will maintain retained earnings in this fund to accumulate monies for relocating utility poles and lines on City arterial roadways underground, as well as provide residents assistance with the process leading to utility undergrounding in residential areas of the City. G.Street Maintenance Fund The City will maintain a minimum of one year's appropriations for road maintenance on Palos Verdes Drive South in the landslide area. H.Habitat Restoration Fund The City will maintain a minimum of $50,000 in this fund as required by the National Communities Conservation Plan (NCCP)for emergency use for habitat restoration purposes in addition to maintaining any interest earnings. I.Subregion One Maintenance Fund As part of the development agreement for Subregion One,the developer provided $750,000 as an endowment to generate interest earnings for future maintenance of the open space area in Subregion One. J.Improvement Authority Abalone Cove Fund In connection with the Horan lawsuit,the Redevelopment Agency's Reimbursement and Settlement Agreement with property owners and the County stipulated that $1,000,000 of County loan proceeds was to be deposited in the Abalone Cove Maintenance Nonexpendable Trust Fund of the Joint Powers Improvement Authority.Interest earnings from this deposit are used to maintain landslide abatement facilities in the Abalone Cove area of the active landslide,except sewers in accordance with the reimbursement and settlement agreement 2 7-13 City Council Policy #41 (Amended) Reserve levels will be reviewed annually during the budget process.Any recommended adjustments to reserve levels will be presented to City Council for its consideration during the annual budget process. COMMITMENTS AND ASSIGNMENTS OF FUND BALANCE: Governmental Accounting Standards Board Statement No.54,Fund Balance Reporling and Governmf3ntal Fund Type Definitions,provides the City with a method to self-classify fund balance for financial statement reporting purposes. A.Committed Fund Balance Fund balance may be committed to specific purposes using its highest level of decision-making authority,the City Council.It is the City Council's policy that commitments of fund balance for a fiscal year must be adopted .by resolution prior to fiscal year end.Amounts that have been committed by the City Council cannot be used for any other purpose unless the City Council adopts another resolution to remove or change the constraint. B.Assigned Fund Balance The General Fund balance may be assigned for amounts the City Council intends to use for a specific purpose.It is the City Council's policy that assignments of fund balance for a fiscal year must be approved by minute-order of the City Council prior to the fiscal year end.Any changes to assignments must also be made by minute-order of the City Council. It is the City Council's policy to spend classified fund balance in the following order when amounts in more than one classification are available for a particular purpose: 1.Restricted Fund Balance -amounts constrained to specific purpose by their providers through constitutional provisions or enabling legislation. Examples include grants,bond proceeds and pass-through revenue from other levels of government. 2.Committed Fund Balance -amounts constrained to specific purpose by resolution of the City Council. 3.Assigned Fund Balance -amounts in the General Fund which are intended to be used for a specific purpose,expressed by minute-order of the City Council. 4.Unassigned Fund Balance -amounts available for any purpose in the General Fund. BACKGROUND: Reserves,rainy-day funds,or contingency funds are a prudent fiscal policy and an important credit factor in the analysis of financial analysis and management. Local governments have experienced much volatility in their financial stability due 3 7-14 City Council Policy #41 (Amended) to the economy,natural disasters,terrorist attacks,and actions taken by state government which includes taking revenues from local governments to resolve state budget problems.California cities are at an even greater disadvantage than the rest of the country due to the unique regulations imposed by Proposition 13,and the inability to raise property taxes if the need would arise.Sound financial management includes the practice and discipline of maintaining adequate reserve funds for known and unknown contingencies.Such contingencies include,but are not limited to:cash flow requirements,economic uncertainties including downturns in the local,state or national economy,local emergencies and natural disasters,loss of major revenue sources,unanticipated operating or capital expenditures,uninsured losses,tax refunds,future capital projects,vehicle and equipment replacement,and capital asset and infrastructure repair and replacement.The establishment of prudent financial reserve policies is important to ensure the long-term financial health of the City. 4 7-15 Criteria I Governments I U.S.Public Finance: Financial Management Assessmel1t Primary Credit Analyst: James Wiemken,London +44-20-7176-7073;james_wiemken@standardandpoors.com Secondary Credit Analysts: Colleen Woodell,New York (1)212-438-2118;colleen_woodell@standardandpoors.com Richard J Marino,New York (1)212-438-2058;richard_marino@standardandpoors.com Table Of Contents Assessing Financial Practices Analytical Framework Assessment Methodology Analytical Process And Supporting Documentation 00116103 www.standardandpoors.com/ratingsdirect 06/27/06 1 ':':;j: Page 1 of 77-16 Attachment C Criteria I Governments I U.S.Pub~ic Finance: Financial Management Assessment (Editor's Note:This criteria article originally was published on June 27,2006.We're republishing it following our periodic review completed on Dec.15,2010.) The rigor of a government's financial management practices is an important factor in Standard &Poor's Ratings Services analysis of that government's creditworthiness.Managerial decisions,policies,and practices apply directly to the government's financial position and operations,debt burden,and other key credit factors.A government's ability to implement timely and sound financial and operational decisions in response to economic and fiscal demands is a primary determinant of near-term changes in credit quality.Standard &Poor's will now offer a more transparent assessment of a government's financial practices as an integral part of our general obligation and appropriation credit rating process. Assessing Financial Practices Major elements of governmental financial management include economic analysis,revenue forecasting,risk management,accounting practices,financial strategies,cash and liquidity administration,and debt management.All of these elements have an impact on a government's bottom line,and,as a result,on its credit quality.If a government is unable or unwilling to employ its authority in a timely manner to address events that impact its budget and financial condition,its credit rating can be adversely affected. Many finance directors and other local government officials take pride in the managerial policies,practices,and structures they have established to ensure efficiency and quality of service,and to promote innovation and security. While credit ratings incorporate financial management as one of many factors,the impact of financial management on the rating may not be readily apparent because other factors may counterbalance,or even outweigh it.Examples of such factors include local economic conditions,debt levels,and statutory limitations.By focusing special attention on the assessment of financial practices,Standard &Poor's will more fully recognize governments'efforts in this important area.In fact,the vast majority of downgrades in recent years can be attributed to financial practices,or lack thereof.(For further information on this trend,see the report,"GO Credit Ratings Are At A Crossroad As Downgrades Increase,"RatingsDirect,June 12,2006). Analytical Framework Standard &Poor's has established an analytical methodology that evaluates established and ongoing management practices and policies in the seven areas most likely to affect credit quality.These areas are: •Revenue and expenditure assumptions •Budget amendments and updates •Long term financial planning •Long term capital planning •Investment management policies •Debt management policies Standard &Poors I RatingsDirect on the Global Credit Portal I June 27.2006 2 00116103 06/27/06 ""1".Page 2 of 77-17 Attachment C Criteria I Governments I U.S.Public Finance:Financial Management Assessment •Reserve and liquidity policies The evaluation of each area focuses on best practices and policies that are credit-important in most governments rather than policies that address issues that are fairly unusual or unique to the government.The nature of the policies and practices considered are those that governments may use in some manner regardless of the size or type of government.Issuers that rank well in the evaluation should be those whose policies help reduce the likelihood of credit deterioration,or enable them to benefit more from changing conditions,whether they are economic, budgetary,statutory,or personnel related. Users of the FMA,however,should also realize its limitations.By focusing on a government's policies and practices, the FMA is not an evaluation of the competency or aptitude of individual finance professionals;nor is it an evaluation of a finance department's ability to handle unique challenges.Moreover,the nature of the entity's governing body,the effectiveness of its governance practices,and issues of public policy pursued by the government are beyond the scope of this analysis. Although Standard &Poor's considers in its analysis any material information that provides relevant context or influences financial management,it is important to note that this assessment of financial practices is based primarily on the existence and implementation of management practices,and not necessarily the results achieved by such practices.Results-both positive and negative-are assumed to manifest themselves in other visible ways.The purpose of the focus on policies and practices is to evaluate the potential for credit quality to move away from those currently indicated by results. The following tables detail each of the seven financial practice areas examined by Standard &Poor's. Table 1 Are the organization's financial assumptions and projections realistic and well grounded from both long-term and recent trend perspectives? Strong Standard Vulnerable Table 2 Formal historic trend analysis is performed and updated annually for both revenue and spending;regular effort is made to determine whether revenues or expenditures will deviate from their long-term trends over the next couple of years;evidence of independent revenue forecasting exists(when possible). Optimistic assumptions exist that.while supportable,add risk;assumptions are based on recent performance, but little evidence of questioning or validating assumptions exists. Assumptions neglect likely shortfalls,expenditure pressures or other pending issues;assumptions exist which enjoy no prudent validation. Are there procedures for reviewing and amending the budget based on updated information and actual performance to ensure fiscal targets are met? Strong Standard Vulnerable At least quarterly budget surveillance is maintained to identify problem areas and enable timely budget adjustments;management exhibits ability and willingness to address necessary intra-year revenue and expenditure changes to meet fiscal targets. Semiannual budget reviews exist;management identifies variances between budget and actual performance. No formal process exists for regular review and timely updating of budget during the year. www.standardandpoors.com/ratingsdirect 00116103 06/27/06 37-18 Attachment C Criteria I Governments I U.S.Public Finance:Financial Management Assessment Table 3 Does management have a long-term financial plan that allows them to identify future revenues and expenditures as well as address upcoming issues that might affect these? A multi-year financial plan exists where future issues are identified and possible solutions are identified, if not implemented;revenue and expenditure decisions are made primarily from a long-term perspective. Strong Structural balance is a clear goal. Multi-year projections are done informally;multi-year projections are done,but without discussion of pending issues,so that issues are not addressed;some one-shot actions exist,but the long-term Standard consequences of these actions are acknowledged and communicated. No long-term financial planning exists;operational planning is done on a year-to-year (or Vulnerable budget-to-budget)basis;one-shot budget fixes are used with little attention to long-term consequences. Table 4 Has the organization created a long-term capital improvement program? •A five-year rolling CIP with funding identified for all years exists and is linked to the operating budget and long-term Strong revenue and financing strategies. A five-year CIP is done,but is generally limited to projects to be funded from the current budget plus a four-year wish Standard list;some funding for out-year projects is identified,but not all. Vulnerable No five-year CIP exists;capital planning is done as needs arise. Table 5 Has the organization established policies pertaining to investments,such as the selection of financial institutions for services and transactions;risk assessment;investment objectives;investment maturities and volatility;portfolio diversification;safekeeping and custody;and investment performance reporting,benchmarking,and disclosure? Investment policies exist and are well defined;strong reporting and Strong monitoring mechanisms exist and are functioning. Informal or non-published policies exist;policies are widely communicated Standard and followed. Vulnerable Absence of informal or non-published policies Table 6 Has the organization established policies pertaining to the issuance of debt,such as projects that mayor may not be funded with debt (including economic development projects);maturity and debt service structure;use of security and pledges,credit enhancement,and derivatives;and debt refunding guidelines? Strong Standard Vulnerable Debt policies exist and are well defined;strong reporting and monitoring mechanisms exist and are functioning.If swaps are allowed,a formal swap management plan that follows S&P's guidelines (see the DDP)has been adopted. Basic policies exist;policies are widely communicated and followed.If swaps are allowed there is a swap management plan in place,but it does not follow S&P's guidelines. Absence of basic policies or clear evidence that basic policies are followed.Swaps are allowed but there is no swap management plan in place.and/or there is no local (non-FA)knowledge about the swap. Standard &Poors I RatingsDirect on the Global Credit Portal I June 27,2006 4 00116103 06/27/06 7-19 Attachment C Criteria I Governments I U.S.Public Finance:Financial Management Assessment Table 7 Has the organization established a formalized operating reserve policy,which takes into account the government's cash flow/operating requirements and the historic volatility of revenues and expenditures through economic cycles? Strong Standard Vulnerable Assessment Methodology A formal operating reserve policy is well defined.Reserve levels are clearly linked to the government's cash flow needs and the historic volatility of revenues and expenditures throughout economic cycles.Management has historically adhered to it. A less defined policy exists,which has no actual basis but has been historically adhered to it. Absence of basic policies or,if they exist,are not followed. Standard &Poor's evaluates and assigns each of the seven areas a qualitative ranking,based on the above framework.In determining the overall assessment,the revenue and expenditure assumptions,budget amendments and updates are given a relatively higher importance;long-term financial planning and liquidity policies are given an average importance;and capital planning,debt policies,and investment policies receive relatively less weight.The difference in degrees of importance is limited,however,so that each factor's contribution to the assessment is meaningful. Overall assessments are communicated using the following terminology:The term "good",in addition to the terms "strong","standard",and "vulnerable",is used to further differentiate governments with a mix of strong and standard practices. "Strong" A Financial Management Assessment of 'strong'indicates that practices are strong,well embedded,and likely sustainable.The government maintains most best practices deemed critical to supporting credit quality and these are well embedded in the government's daily operations and practices.Formal policies support many of these activities, adding to the likelihood that these practices will be continued into the future and transcend changes in the operating environment or personnel. "Good" A Financial Management Assessment of 'good'indicates that practices are deemed currently good,but not comprehensive.The government maintains many best practices deemed as critical to supporting credit quality, particularly within the finance department.These practices,however,may not be institutionalized or formalized in policy,may lack detail or long-term elements,or may have little recognition by decision makers outside of the finance department. "Standard" A Financial Management Assessment of 'standard'indicates that the finance department maintains adequate policies in most,but not all key areas.These policies often lack formal detail and institutionalization,and may not include best practices. "Vulnerable" A Financial Management Assessment of 'vulnerable'indicates that the government lacks policies in many of the areas deemed most critical to supporting credit quality.The 'vulnerable'designation suggests a high degree of uncertainty regarding a government's ability to effectively adapt to changing conditions that could threaten its www.standardandpoors.com/ratingsdirect 00116103 06/27106 57-20 Attachment C Criteria I Governments I U.S.Public Finance:Financial Management Assessment long-term financial position. Analytical Process And Supporting Documentation To perform its analysis of local government financial practices,Standard &Poor's will rely on documentation provided by the government and discussions with the organization's management.Relevant documents include,but are not limited to,audited financial statements and accompanying notes,budget documents,fi~ancial plans, management policy statements,procedure manuals,and periodic reports.Discussions provide an important opportunity for management to elaborate on the factors listed above,as well as answer specific questions,so as to enable Standard &Poor's analysts to assess the factors as thoroughly as possible. Standard &Poors I RatingsDirect on the Global Credit Portal I June 27.2006 6 00116103 06/27/06 r,r::rlr .Page 6 of 77-21 Attachment C Copyright ©2012 by Standard &Poors Financial Services LLC (S&Pj,a subsidiary of The McGraw-Hili Companies,Inc.All rights reserved. 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S&P may receive compensation for its ratings and certain credit-related analyses,normally from issuers or underwriters of securities or from obligors.S&P reserves the right to disseminate its opinions and analyses.S&P's public ratings and analyses are made available on its Web sites,www.standardandpoors.com (free of chargel,and www.ratingsdirect.com and www.globalcreditportal.com (subscription!.and may be distributed through other means,including via S&P publications and third-party redistributors.Additional information about our ratings fees is available at www.standardandpoors.com/usratingsfees. www.standardandpoors.com/ratingsdirect 00116103 06/27/06 7 7 of77-22 Attachment D BEST PRACTICE Appropriate Level of Unrestricted Fund Balance in the General Fund (2002 and 2009)(BUDGET and CAAFR) Background.Accountants employ the term fund balance to describe the net assets of governmental funds calculated in accordance with generally accepted accounting principles (GAAP).Budget professionals commonly use this same term to describe the net assets of governmental funds calculated on a government's budgetary basis.l In both cases,fund balance is intended to serve as a measure of the financial resources available in a governmental fund. Accountants distinguish up to five separate categories of fund balance,based on the extent to which the government is bound to honor constraints on the specific purposes for which amounts can be spent:nonspendable fund balance,restricted fund balance,committed fund balance,assigned fund balance,and unassigned fund balance?The total of the last three categories,which include only resources without a constraint on spending or for which the constraint on spending is imposed by the government itself,is termed unrestricted fund balance. It is essential that governments maintain adequate levels of fund balance to mitigate current and future risks (e.g., revenue shortfalls and unanticipated expenditures)and to ensure stable tax rates.Fund balance levels are a crucial consideration,too,in long-term financial planning. In most cases,discussions of fund balance will properly focus on a government's general fund.Nonetheless, financial resources available in other funds should also be considered in assessing the adequacy of unrestricted fund balance (i.e.,the total of the amounts reported as committed,assigned,and unassigned fund balance)in the general fund. Credit rating agencies monitor levels of fund balance and unrestricted fund balance in a government's general fund to evaluate a government's continued creditworthiness.Likewise,laws and regulations often govern appropriate levels of fund balance and unrestricted fund balance for state and local governments. Those interested primarily in a government's creditworthiness or economic condition (e.g.,rating agencies)are likely to favor increased levels of fund balance.Opposing pressures often come from unions,taxpayers and citizens'groups,which may view high levels of fund balance as "excessive." Recommendation.The Government Finance Officers Association (GFOA)recommends that governments establish a formal policy on the level of unrestricted fund balance that should be maintained in the general fund.3 Such a guideline should be set by the appropriate policy body and should provide both a temporal framework and 1 For the sake of clarity,this recommended practice uses the terms GAAP fund balance and budgetary fund balance to distinguish these two different uses of the same term. 2 These categories are set forth in Governmental Accounting Standards Board (GASB)Statement No.54,Fund Balance Reporting and Governmental Fund Type Definitions,which must be implemented for fmancial statements for periods ended June 30,2011 and later. 3 Sometimes restricted fund balance includes resources available to fmance items that typically would require the use of unrestricted fund balance (e.g.,a contingency reserve).In that case,such amounts should be included as part of unrestricted fund balance for purposes of analysis. 7-23 Attachment D specific plans for increasing or decreasing the level of unrestricted fund balance,if it is inconsistent with that policy.4 The adequacy of unrestricted fund balance in the general fund should be assessed based upon a government's own specific circumstances.Nevertheless,GFOA recommends,at a minimum,that general-purpose governments, regardless of size,maintain unrestricted fund balance in their general fund of no less than two months of regular general fund operating revenues or regular general fund operating expenditures.5 The choice of revenues or expenditures as a basis of comparison may be dictated by what is more predictable in a government's particular circumstances.6 Furthermore,a government's particular situation often may require a level of unrestricted fund balance in the general fund significantly in excess of this recommended minimum level.In any case,such measures should be applied within the context of long-term forecasting,thereby avoiding the risk of placing too much emphasis upon the level of unrestricted fund balance in the general fund at anyone time. In establishing a policy governing the level of unrestricted fund balance in the general fund,a government should consider a variety of factors,including: •The predictability of its revenues and the volatility of its expenditures (i.e.,higher levels of unrestricted fund balance may be needed if significant revenue sources are subject to unpredictable fluctuations or if operating expenditures are highly volatile); •Its perceived exposure to significant one-time outlays (e.g.,disasters,immediate capital needs,state budget cuts); •The potential drain upon general fund resources from other funds as well as the availability of resources in other funds (i.e.,deficits in other funds may require that a higher level of unrestricted fund balance be maintained in the general fund,just as,the availability of resources in other funds may reduce the amount of unrestricted fund balance needed in the general fund);7 •Liquidity (i.e.,a disparity between when financial resources actually become available to make payments and the average maturity of related liabilities may require that a higher level of resources be maintained); and •Commitments and assignments (i.e.,governments may wish to maintain higher levels of unrestricted fund balance to compensate for any portion of unrestricted fund balance already committed or assigned by the government for a specific purpose). Furthermore,governments may deem it appropriate to exclude from consideration resources that have been committed or assigned to some other purpose and focus on unassigned fund balance rather than on unrestricted fund balance. Naturally,any policy addressing desirable levels of unrestricted fund balance in the general fund should be in conformity with all applicable legal and regulatory constraints.In this case in particular,it is essential that differences between GAAP fund balance and budgetary fund balance be fully appreciated by all interested parties. Approved by the GFOA's Executive Board,October,2009. 4 See Recommended Practice 4.1 of the National Advisory Council on State and Local Budgeting governments on the need to "maintain a prudent level of financial resources to protect against reducing service levels or raising taxes and fees because of temporary revenue shortfalls or unpredicted one-time expenditures"(Recommended Practice 4.1). 5 In practice,a level of unrestricted fund balance significantly lower than the recommended minimum may be appropriate for states and America's largest governments (e.g.,cities,counties,and school districts)because they often are in a better position to predict contingencies (for the same reason that an insurance company can more readily predict the number of accidents for a pool of 500,000 drivers than for a pool of fifty),and because their revenues and expenditures often are more diversified and thus potentially less subject to volatility. 6 In either case,unusual items that would distort trends (e.g.,one-time revenues and expenditures)should be excluded, whereas recurring transfers should be included.Once the decision has been made to compare unrestricted fund balance to either revenues or expenditures,that decision should be followed consistently from period to period. 7 However,except as discussed in footnote 4,not to a level below the recommended minimum. 2 7-24