Operating Reserves: How much do we need?

We regularly get questions on the appropriate level of funding for an operating reserve. This post will attempt to summarize key concepts and general guidance for maintaining an adequate operating reserve.

Like many issues in local government, the municipality’s unique situation and the characteristics of the community it serves should have a large influence on its approach. Keep this in mind as the specifics in your community may warrant different approaches than those covered here in relation to funding an operating reserve.

What is an operating reserve?

Operating reserves are dedicated municipal monies that are available to cover budgetary shortfalls or unexpected expenditures.

Such reserves generally take one of two different forms:

A dedicated fund – a dedicated fund can be created to serve as an operating reserve. Sometimes these funds are referred to as “rainy day funds.” As with all funds, an operating reserve fund should be accounted for separately and the monies in the fund should not be mingled with other municipal funds. The Borough Code in section 1202 (23) states that such operating reserve funds can have no more than 25 percent of the current fiscal year’s estimated revenues within the fund. So, for instance, if your estimated revenues for the general fund are $I million, a maximum of $250,000 could be held in your separate operating reserve fund.

A fund balance – Instead of, or in addition to, creating a separate operating reserve fund, some communities provide for operating reserves by carrying an unrestricted fund balance in their general fund. This is the portion of your fund balance, or cumulative budgetary surplus, that is completely unencumbered and can be used as a reserve to counterbalance unexpected expenditures and budgetary shortfalls. Unlike the limitations placed on operating reserve funds, the Borough Code does not cite a limit to levels for unreserved fund balances relative to estimated annual revenue. This is significant, as in some cases circumstances may dictate carrying more than 25% of your estimated annual revenues in reserve.

Appropriate reserve levels

As was mentioned in the introduction, the appropriate level of operating reserve funding will be dictated by your local circumstance. Some communities due to limitations on revenue sources, or local economic factors may find it prudent to hold more than others in reserve. For instance, if economic activity in your community is tied almost exclusively to a specific industry or major business, a greater hedge of reserves may be warranted compared to communities with more diverse economic activity.

There are several sources of guidance on what constitutes a healthy operating reserve level.  The Government Finance Officers Association (GFOA) states that a minimum of two months operating expenditures or revenues (or around 17% of your annual estimated revenues or expenditures) should be held as an operating reserve.

Why is maintaining an operating reserve important?

A healthy operating reserve is a key indicator of overall financial health for municipalities. Such reserves can be used as a hedge against cyclical economic downturns that cannot be easily predicted. A healthy operating reserve acts, in a way, as an insurance policy to protect against unexpected expenditures that your budget cannot absorb. These reserves can keep your borough’s operations stable for a period of time should your community’s economy be disrupted suddenly. Many bond rating agencies use operating reserve funding levels as a key metric for assessing the overall financial condition of a municipality. Communities with healthy reserves are more likely to receive a higher bond rating and pay less interest on debt they issue.

Consider a policy

Given the importance of maintaining a healthy operating reserve, borough council may want to consider adopting a policy that provides guidance on your objectives in relation to your operating reserve.

The policy, which can be adopted by resolution, might cover, but is not limited to items such as the following:

  • reserve balance targets (percentage of estimated annual revenue or operating expenses)
  • details on how the reserve is to be funded
  • limitations on how and when monies can be spent from the reserve
  • procedures for authorization to spend monies from the reserve
  • guidance on how quickly the reserve is to be replenished if it falls below target levels

An adequate operating reserve provides borough officials with greater peace of mind that their community is able to weather a financial storm. With a policy in place that prioritizes the maintenance of such a reserve, you can better ensure that sufficient operating reserves will be provided for and preserved.