What’s the Point of Rainy Day Funds?

States and localities both save for unseen emergencies and hard times. But when it comes to using the funds, their approach couldn't be more different.
by | June 2013

Wallace Sayre, an early and influential scholar of public management, once said public and business administration are “alike only in all unimportant respects.” His insight applies equally to states and localities and their rainy day funds. Both put money aside for unforeseen emergencies or hard times. But states use these funds to solve problems. Many local governments use them -- or don’t -- in ways that reveal problems.

Among the states, rainy day funds have been the best (and in some cases the only) tool available to blunt the Great Recession’s fiscal destruction. During the good years prior to the downturn, most states built up 5 to 10 percent of annual expenditures in their funds. During the recession and the ever-so-slow recovery, they spent almost all of that money to fill budget gaps created when revenues fell short and service demands spiked.

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Most local governments do not have formal rainy day funds in the same way most states do. A typical state rainy day fund is governed by a law that sets a target fund balance and dictates when to use and replenish that balance. According to recent research, only 11 of the 30 largest U.S. cities have an actual rainy day fund. Instead, most localities use budget surpluses or unreserved fund balances as a rainy day fund, but one without the constraints of a formal fund policy. These informal practices are not necessarily bad, but they’re not as transparent as most state policies.

Unlike states’ funds, local reserve levels are large and varied. Where state rainy day fund balances have hovered around 5 to 8 percent of annual spending, local governments tend to keep much more in the bank. In my own analysis of more than 6,000 local government financial reports from the past five years, I found the average local unreserved general fund balance to be around 34 percent of annual general fund expenditures. Even more striking is how much these local balances vary. It’s not uncommon to see a group of local governments with 0 percent fund balances and a nearly identical group of jurisdictions with fund balances at 70 to 80 percent of annual spending.

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Here’s the most important difference: Unlike the states, local governments did not spend down their reserves during the Great Recession. In fiscal 2007 the average local unreserved general fund balance was 37 percent of annual general fund expenditures. In 2009, as the recession began to take hold, it fell to 29 percent. But by 2011, as the recovery struggled to start, it was back up to 31 percent. In the meantime, operating margins -- or the percent by which revenues exceed expenditures -- fell from an average of 6 percent in 2007 to an average of less than 1.5 percent in 2011. To be clear, about one in four of these governments did spend down most or all of their reserve funds. But the vast majority, including several with large reserve funds, reduced spending instead.

Why were local governments reticent to spend reserve funds during one of the stormiest eras in history? On the record, many local finance officials say they would prefer to use those funds to take on an idiosyncratic problem, such as a flood or the loss of a major local employer. Off the record, they will tell you it has a lot to do with citizens’ lack of understanding of what local government services really cost. Some say, “If we spend it, we won’t get it back.” In other words, the pressure to keep taxes low is so great that they would never be able to replenish the reserves with new incremental revenues. Others say, “I can’t spend it because my council wants our reserve funds higher than the (neighboring) city of X.” Translation: High reserve funds are a signal of strength and prosperity precisely because you don’t really need them. Until we can address these much larger issues of perceptions, local rainy day funds will be a symptom rather than a solution.

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