Attachment 2ATTACHMENT 2
ATTACHMENT A
A RISK-BASED ANALYSIS OF GENERAL FUND RESERVE REQUIREMENTS FOR
THE CITY OF NEWPORT BEACH, CALIFORNIA
DRAFT – MAY 2018
A Risk-Based Analysis of General Fund Reserve
Requirements for the City of Newport Beach,
California
Draft – May 2018
Produced by:
The Government Finance Officers Association
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Table of Contents
Section 1 - Executive Summary ..................................................................................................................... 3
Section 2 - Introduction ................................................................................................................................ 6
Section 3 - The Approach to Uncertainty ...................................................................................................... 8
Section 4 - Extreme Events ......................................................................................................................... 12
Section 5 - Revenue Volatility ..................................................................................................................... 33
Section 6 - Secondary Risks ......................................................................................................................... 43
Section 7 - Putting it All Together ............................................................................................................... 50
Section 8 - Next Steps ................................................................................................................................. 55
Section 9 - Appendix 1: Reserves in Comparable Cities .............................................................................. 56
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Section 1 - Executive Summary
A local government’s “reserves” are the portion of fund balance serves as a hedge against risk. The City of
Newport Beach (City) has asked the question: “what is the right amount of general fund reserves for us?”
The Government Finance Officers Association (GFOA) has helped the City answer this question by
examining the risks that the City is subject to.
First, we identified the risks that posed the most clear and present danger to the City. According to the
City’s disaster management plan, these include earthquakes, floods, and fires. Landslides and high winds
could also be potentially damaging, but less so than earthquakes, floods, and fires. We also accounted for
the other risks, such as the potential for decreased revenues and increased pension costs due to an
economic downturn.
Next, for each risk we calculated the probability that the City would experience one of the aforementioned
risks over a ten-year period and, if an event did occur, what the magnitude of the loss would be for the
City’s general fund. To calculate the probability and magnitude of events, we primarily used the following
sources of data:
• Newport Beach’s own experience. For example, the City’s revenue losses during 2001
“Dot.Bomb” recession and 2007 “Great Recession” provide insight into the potential losses the
City could incur during a future recession.
• The experience of other California cities. Fortunately, Newport Beach hasn’t had a lot of direct
experience with many of the extreme events it is at risk for. The experiences of other California
cities can serve as analogues.
• Research produced by other agencies. For example, the United States Geological Survey makes
available information on the likelihood of earthquakes in the Los Angeles area.
• Expertise of City staff. City staff work every day on preparing the City for the risks it faces. Staff
helped us fill in gaps in the source of data above. For example, the City’s fire chief helped
estimate the cost to respond to a wildfire.
We modeled each risk individually and then combined each individual risk into a ten-year model of the
City’s reserves. Our analysis produced the graph below. The vertical axis represents a given amount of
reserves that the City might choose to hold. The horizontal axis represents the level of confidence the City
could have that a given amount of reserves would be sufficient to cover the losses the City might incur
over a ten-year period. For example, the City can be 80% confident that a reserve of $10.4 million would
cover the City’s extraordinary general fund expenditures for the risks covered in this report over a ten-
year period.
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Exhibit 1.1: Confidence that a Given Level of General Fund Reserves will be Sufficient over 10 Years
Reserves
(Millions
of
Dollars)
Percent Confidence
GFOA cannot prescribe a precise level of reserves because the exact amount the City might wish to
maintain is a product of the City’s appetite for risk. However, we can make a number of suggestions to
help the City identify a risk management strategy that makes sense for Newport Beach.
• There is a point at which the curve begins to rise sharply. This is the point at which the City starts
to receive less value from reserves. In the graph above, this is between the 80% confidence level
($10.4 million) and 90% confidence level ($13.0 million). This represents the range at which
reserves produce the best value for the City.
• The City should supplement reserves with other risk management strategies. Understandably,
City officials might not be satisfied with an 80% or 90% chance of being able to cover damages
from the risks we described in this report. Other financial risk management tools like debt or
insurance could be used to provide additional confidence.
• The City may wish to have some reserves beyond our efficient range to account for the fact that
our analysis cannot account for every risk the City could possibly experience. Our analysis does
cover the most clear and present dangers to the City, but some additional amount of reserves
could be prudent.
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• The City can examine the reserves held by comparable cities. Our examination of comparable
cities suggests that the efficient range of reserves we found is in line with the emergency reserves
maintained by other cities.
• The City could elect to hold more reserves than our recommended efficient range based on global
climate change. Our analysis is based on historical records. Global climate change could increase
the City’s vulnerability to naturally occurring extreme events.1 Hence, historical data could
underestimate the likelihood and/or severity of extreme events in the future. Unfortunately, no
one can say precisely what the impact of climate change will be. Hence, GFOA could not make an
objective adjustment to the results of our analysis. This means that there could be a case for
reserving a higher amount than the efficient range described above (or pursuing other risk
management strategies). GFOA’s Microsoft Excel risk model 2 provides the City with the ability to
adjust the likelihood and/or magnitude of future extreme events, if it would like to test different
scenarios. For example, if we were to double the likelihood of a flood then the 80% and 90%
confidence levels increase to $10.8 million and $13.5 million, respectively.
• Select a range of preferred reserves, instead of a single target number. GFOA’s research into how
local governments can best maintain financial sustainability has found that decision-making
“boundaries” are essential. For example, if the City were to adopt a policy to maintain reserves
between X% and Y% of revenues, then that would constitute a clear boundary that defines when
reserves are too high and too low. Compare this to if the City just adopted a policy of that reserves
should be at X% of revenues. It is then impossible to say how far reserves can go above or below
this number and still be at acceptable levels. A range also can accommodate the risk appetites of
more City officials. Thus, a range might be more reflective of the preferences of a greater number
of people.
1 According to “The Impact of Climate Change on Natural Disaster”, an article from NASA’s “Earth Observatory”:
“outcomes of an increase in global temperatures include increased risk of drought and increased intensity of storms,
including tropical cyclones with higher wind speeds, a wetter Asian monsoon, and, possibly, more intense mid-
latitude storms.” https://earthobservatory.nasa.gov/Features/RisingCost/rising_cost5.php?src=share
2 GFOA provides the model to the City so that the City can update the model on its own.
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Section 2 - Introduction
“Reserves” are the portion of a local government’s fund balance that are available to respond to the
unexpected. Reserves are the cornerstone of financial flexibility. Reserves provide a government with
options to respond to emergencies and afford a buffer against shocks and other forms of risk. Managing
reserves, though, can be a challenge. Foremost, is the question of how much money to maintain in a
general fund reserve? How much is enough and when does a reserve become too much? This can be a
sensitive question because money held in reserve is money taken from constituents, and the argument
could be made that excessive reserves should be returned to residents in the form of lower taxes/fees or
enhanced services.
The City of Newport Beach has been considering this question recently, especially given its vulnerability
to extreme events like earthquakes and floods and because of the potential for revenue instability owing
to an economic downturn. The City engaged the GFOA to help produce a recommendation to help the
City decide how much reserves is appropriate for the general fund. GFOA is a non-profit association of
over 19,000 state and local government finance professionals and elected officials from across North
America. A key part of GFOA’s mission is to promote best practices in public finance, including reserve
policies.
GFOA’s approach to reserves does not suppose “one-size-fits-all.” But, GFOA’s “Best Practice” on general
fund reserves recommends, at a minimum, that general-purpose governments, regardless of size,
maintain reserves of no less than two months of regular operating revenues or regular operating
expenditures (i.e., reserves equal to about 16.7 percent of revenues).3 However, this 16.7 percent is only
intended as a rule-of-thumb, and it needs to be adjusted according to local conditions. To make the
adjustment, GFOA worked with the City to conduct an analysis of the risks influencing the need for
reserves as a hedge against uncertainty and loss.
A “risk” is defined as the probability and magnitude of a loss, disaster, or other undesirable event.4 The
GFOA’s framework of risk assessment is based on the risk management cycle: identify risk; assess risk;
identify risk mitigation approaches; assess expected risk reduction; and select and implement mitigation
methods. The framework focuses primarily on risk retention, or using reserves, to manage risk. However,
the framework also encourages the City to think about how other risk management methods might
alleviate the need to hold larger reserves. In other words, can the City manage its risks in some other way
besides holding reserves? For example, could insurance or debt instruments complement the City’s
reserve strategy? A thorough examination of the risk factors should lead to a range of desired reserves
and improve the City’s understanding of its overall risk profile.
3 GFOA Best Practice. “Appropriate Level of Unrestricted Fund Balance in the General Fund.” GFOA. 2009.
4 Definition of risk taken from: Douglas W. Hubbard. The Failure of Risk Management: Why It’s Broken and How to
Fix It. John Wiley and Sons, Inc. Hoboken, New Jersey. 2009.
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As a first step to this project, GFOA conducted a review of the risk factors influencing the amount of
reserves a municipal government should hold.5 This review enabled the City and GFOA to classify factors
as either primary or secondary risks. Exhibit 1.1 lists how the risk factors were classified.
Exhibit 2.1 – Categorization of Risk Factors that Influence Reserve Levels for Newport Beach
Primary Risk Factors
Vulnerability to extreme events and public safety concerns, with emphasis on:
• Earthquakes
• Floods (includes landslides and tsunamis)
• Fires
• High Winds
Revenue source stability, particularly as it relates to the potential for revenue decline from an economic downturn
Secondary Risk Factors
Pension costs increase owing to underperformance of plan assets during an economic downturn
Leverage from indebtedness (other than pensions)
Liquidity concerns
Expenditure spikes (e.g., from impending lawsuits)
Growth
The next section gives an overview of how we analyze these risks and what you can expect to see in the
rest of this report.
5 The risk factors and basic review method were developed and published in the GFOA publication: Shayne C.
Kavanagh. Financial Policies. (Government Finance Officers Association: Chicago, IL) 2012.
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Section 3 - The Approach to Uncertainty
The accomplished forecasting scientist, Spyros Makridakis, suggests a “Triple-A” approach for dealing with
highly uncertain phenomena.6
1. Accept. First we must accept that we are subject to uncertainty. For example, earthquakes could
experience a great deal of variability, from a barely noticeable tremor to “the big one”.
2. Assess. Next, we must assess the potential impact of the uncertainty, with history providing a
useful reference point. The experiences of other local governments is also a good reference point.
For example, we used the historical experiences of Newport Beach and other California cities to
estimate the potential impact of future extreme events.
3. Augment. The range of uncertainty we actually face will almost always be greater than what we
initially assess it to be. Therefore, we must augment our understanding of risk beyond what our
historical experiences show us. For example, the City has not experienced a major wildfire
recently. This does not mean there is no risk of a future wildfire. Also, the City has not experienced
a major earthquake, but it could in the future. We can augment our understanding of risk using
a technique called “Probability Management”.7 Probability Management is an application of
modern information processing technology that allows us to simulate thousands of potential
events (e.g., wildfires, earthquakes) so that we can observe the probability of events of various
magnitudes coming to pass.
In order to use Probability Management, we express any given type of extreme event as a range of
possibilities that the City might experience. This range is called a “distribution”. A distribution is a shape
that signifies how frequently the City might expect to experience a certain type of event and/or how
severe the event might be. The most common type of distribution is called the “normal distribution”,
more popularly known as the “bell curve”. Many phenomena fit a bell curve. To help us understand how
to read a distribution, we can start with an example that is related to everyday life: Exhibit 3.1 shows a
bell curve for the height of American men. The horizontal axis of Exhibit 3.1 represents height. The vertical
axis represents frequency. 5’9” is the most common height, so it is shown at the top of the curve. Much
taller men, like NBA centers, would be found on the right-hand side of the curve. Very short men would
be found on the left.
6 See: Spyros Makridakis, Robin Hogarth, and Anil Gaba. Dance with Chance: Making Luck Work for You. (Oneworld
Publications: Oxford, England). 2009.
7 The discipline of “Probability Management” was developed by Dr. Sam Savage, author of The Flaw of Averages.
You can learn more about Probability Management at probabilitymanagement.org.
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Exhibit 3.1 – The Normal Distribution for American Men
Frequency
Height
The normal distribution can help analyze the City’s risk. To illustrate, the severity of an economic
downturn is roughly normally distributed. A few economic downturns are slight, few are severe, but most
are closer to average.
Another common type of distribution we use in our analysis is called a “lognormal” distribution. A
lognormal distribution is shown in Exhibit 3.2. Earthquakes, for example, fit a lognormal distribution.
Exhibit 3.2 shows that tremors of a small magnitude are the most common type of earthquake, by far.
Large magnitude earthquakes are very rare.
Exhibit 3.2 – Lognormal Distribution for Earthquakes
Frequency
Magnitude
Very Short Very Tall
Average
5’9”
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Expressing Newport Beach’s vulnerability as distributions allows us to calculate the probability that an
event of a given magnitude will come to pass. When we associate a dollar amount with that event, we can
estimate the probability or chance that Newport Beach will need to have a given amount of money on-
hand to respond. Exhibit 3.3 is not a distribution, but is a type of graphic we will use often in this report.
It is called a “cumulative probability chart”. It shows that increasing amounts of reserves are needed to
gain more confidence that the City will have enough money to cover the extraordinary cost to the general
fund arising from an earthquake. We can see that reserving $2.0 million will give the City a 90% chance of
being able to cover the costs that the general fund would incur as a result of an earthquake. The curve is
relatively flat for most of the chart and then begins to move sharply upward. This is because increasingly
large amounts of money are needed to cover the costs from the most extreme earthquakes.
Exhibit 3.3 - Percent of Earthquake’s Covered by Varying General Fund Reserve Levels
As we move to the right of the graph, the amount Newport Beach needs to reserve to cover the cost
of an earthquake increases. At the top right, as the line color changes to orange, it indicates an
increasing level of reserves to address greater than 95% confidence level.
For most risks the City faces, GFOA recommends a range of possible reserve amounts for the City to
consider. This is because there is never one single, objectively best amount of reserves to hold. The
amount of reserves the City will want hold will partially be a function of the City’s willingness to take on
risk. If City officials are willing to take on risk, they might opt for lower reserves and spending more money
on current services. If officials are more risk averse, they might opt for higher reserves. GFOA’s
recommended ranges of reserves are based on where reserves produce the best value or “bang for the
buck”. For example, on Exhibit 3.3 we see that to go from 95% confidence to 99% confidence would
require an extraordinary amount of money. Conversely, to go from 75% to 80% does not cost nearly as
much. Hence, we recommend that the City pick reserve targets that offer the best value. On Exhibit 3.3,
we see that range lies between $1.1 million and $2.0 million for earthquakes. Other strategies for covering
risk beyond these amounts may be more financially savvy (e.g., debt or insurance).
$0.0
$1.0
$2.0
$3.0
$4.0
$5.0
$6.0
5%10%15%20%25%30%35%40%45%50%55%60%65%70%75%80%85%90%95%99%
Mi
l
l
i
o
n
s
At 85% confidence level,
the City would require
$1.1 million in reserves.
At 90% confidence level,
the City would require
$2.0 million in reserves.
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In Section 4 of this report, we will review all of the City’s primary risks posed by extreme events. In Section
5, we cover revenue instability owing to economic downturns. We will analyze them in the manner
described above and suggest where reserves offer the greatest value. Section 6 reviews secondary risk
factors that have less weighty implications for the City’s reserve strategy. These risks will be analyzed in a
similar way to the primary risks.
After we analyze the individual risks, in Section 7, we will consider the risks holistically. This section will
address the following concerns:
• It is highly unlikely that the City will experience many of the extreme events discussed in this
report in a short time period. This means that simply adding the reserve amounts for each event
on top of one another would cause the City to reserve more than its appetite for risk suggests is
needed.
• Considering the risks over a multi-year time period provides a more complete perspective on
potential vulnerability and how to use reserves.
• The occurrence of one risk could impact the likelihood of another. For example, a severe economic
downturn could lead to lower returns on the City’s pension assets, leading to higher pension costs.
In Section 8, we provide our recommended steps for how the City might move forward using our analysis.
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Section 4 - Extreme Events
Although Newport Beach has received reimbursement from insurance and public agencies in the past for
natural disasters and has insurance coverages that would help in recovery from future disasters, having
adequate reserves in place is important to
quickly and decisively respond to extreme
events. For example, FEMA reimbursement
will not over all the costs the City incurs and it
could be months, if not years, to receive
reimbursement. As the City’s hazard
mitigation plan indicates, earthquakes,
floods, wildfires, landslides, and strong winds
are potentially the most costly natural
disasters for Newport Beach.8 In discussions
with City staff, the first three disasters
represent the greatest risk and will be the
focus of this section of the analysis.
Fortunately, Newport Beach has not experienced a substantial earthquake in recent history. Therefore,
we have no historical data to suggest what damage an earthquake might do. Instead, we will rely on
historical data for earthquakes that have occurred in other areas in California. We use these cases to
establish the range of potential damage that Newport Beach might experience.
We cannot assume that all
the points along the range of
potential damages is equally
likely – for example, it is more
likely that Newport Beach will
experience seismic activity of
smaller magnitude than a
large seismic event. Theory
suggests, and our
examination of the data
confirms, that the range of
potential damages takes the
shape of a lognormal curve.
Simply stated, Newport
Beach is much more likely to
incur natural disasters of less severity and lower cost with greater frequency than higher cost, more severe
8 City of Newport Beach, CA, “Local Hazard Mitigation Plan,” 2016.
FEMA, CalOES, and Reserves
The U.S. Federal Emergency Management Agency
(FEMA) reimburses local governments for monies spent
in response to a federally-declared disaster. The
California Governor's Office of Emergency Services
(CalOES) provides assistance to local governments for
State of California-declared disasters.
In both cases, reimbursement is only partial (typically
75 percent for FEMA) and is often not immediate.
Therefore, local governments must have the financial
capacity to respond quickly and decisively,
independent of other governmental financial support.
Frequency
of Quake
Exhibit 4.1 – Sample Lognormal Curve
Severity of Quake
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natural disasters.9 For illustrative purposes, the image above is a lognormal curve of seismic activity. The
odds of experiencing tremors is much greater than the odds of experiencing earthquakes. It is also
significantly more likely that the City experiences tremors than a catastrophic event (“The Big One”).
The severity of earthquakes, floods, and wildfires are attributable to several factors. Factors impacting
the severity of earthquakes include magnitude, density of an area, depth of the earthquake, distance from
the epicenter, local geological conditions, secondary effects (e.g., floods, landslides, fires), and
architecture.10 Factors impacting the severity of floods include amount of precipitation as well as the size,
shape, and land use of the surface area where rainwater reaches.11 Factors influencing the severity of fires
include topography, temperature and relative humidity, and vegetation.12 In addition, an area’s level of
preparedness to respond13 to a natural disaster affects severity and cost. Controlling for many of these
factors is beyond the scope of our analysis. Therefore, in the following subsections, we select proxy
variables (such as population density) to help estimate the impact an extreme event will have on Newport
Beach. We will also return to specific factors affecting Newport Beach’s potential damages from these
hazards based on the City’s natural hazards mitigation plan later in this report when we recommend an
overall reserve strategy.
Because the City does not have information on cost of past earthquakes and wildfires, we gathered
additional sources of data. This includes reference cases using publically available data from FEMA-
declared disasters.14 Additionally, we use other Southern California FEMA-declared disasters as additional
analogues to the three floods for which the City has cost information. There are two important limitations
with these datasets. One is the reference information may represent instances of greater damage than
what the City may experience. The second limitation is the FEMA information includes all cost
reimbursement, including those to the general and enterprise funds. The following sections on each type
of extreme event will further explain any notable features of the data sets we used.
Subsection A - Earthquakes
Developing a reserve strategy for a severe natural disaster is complicated because a disastrous earthquake
is a very low probability event with potentially extreme consequences. Unlike, for example, a recession
9 GFOA used standard statistical procedures to turn the data from Exhibit 2 into a lognormal distribution.
10 Sarah Zielinski, “Seven Factors that Contribute to the Destructiveness of an Earthquake,” Smithsonian, February
23, 2011, http://www.smithsonianmag.com/science-nature/seven-factors-that-contribute-to-the-destructiveness-
of-an-earthquake-44395116/.
11 Ross Gorte, “The Rising Cost of Wildfire Protection,” (Bozeman, MT: Headwater Economics, 2013),
http://headwaterseconomics.org/wphw/wp-content/uploads/fire-costs-background-report.pdf.
12 Becky L. Estes, Eric E. Knapp, Carl N. Skinner, Jay D. Milner, and Haiganoush K. Preisler, “Factors influencing
fire severity under moderate burning conditions in the Klamath Mountains, northern California, USA,” Ecosphere 8:
5 (2017), 1-20, http://onlinelibrary.wiley.com/doi/10.1002/ecs2.1794/pdf.
13 The State of Queensland, Office of the Queensland Chief Scientist, “What factors contribute to floods?,”
http://www.chiefscientist.qld.gov.au/publications/understanding-floods/what-factors-contribute.
14 FEMA Public Assistance Funded Projects Summary provides information on “Federal disaster grant assistance for
debris removal, emergency protective measures, and the repair, replacement, or restoration of disaster-damaged,
publicly owned facilities and the facilities of certain Private Non-Profit (PNP) organizations.” Federal Emergency
Management Agency, “FEMA Public Assistance Funded Projects Summary,” http://www.fema.gov/media-
library/assets/documents/28344, updated December 8, 2017.
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that will almost certainly happen within the foreseeable future due to routine economic cycles, Newport
Beach may not experience a severe earthquake for many years. For a risk factor like revenue volatility
(due to a recession) it makes sense to reserve an amount that is within the relatively well-defined range
suggested by the City’s historical experiences because we know that: A) a recession will happen in the
foreseeable future, and B) certain tax revenues will decline by a roughly predictable amount at that time.
To deal with the unique problems posed by a severe earthquake, we turn to the emerging field of
municipal “resiliency.”15 Resiliency is defined as a government’s ability to absorb an extreme event and
bounce back from it. Further, resiliency is enhanced when a government has multiple options to respond
to an extreme event. When considering financial preparedness to respond, a municipality has three basic
options.
• Reserves. Reserves are under the complete control of a municipality, thus provide the most
flexibility.
• Debt. A municipality could access the debt market to pay for costs of responding.
• Insurance. A municipality could purchase insurance to provide reimbursement of costs incurred.
For a lower probability event with potentially extreme consequences, there are disadvantages to relying
exclusively on reserves. Chief among them include, the length of time to accumulate sufficient reserves
to cover the costs associated with a catastrophic event and the important opportunity costs of holding
these monies in reserve – for example, a municipality could use the money to lower taxes or provide more
services. The resiliency philosophy suggests that we should think about how all three options could be
used to create financial preparedness to deal with an extreme event or a natural disaster.
In order to think about how the three funding mechanisms above might apply to the City’s financial
preparedness strategy for earthquakes, we first need to better define the range of damages the City could
experience. To do this, we draw from earthquake events listed in FEMA’s database for California cities
and towns. The reference examples reflect a similar seismic hazard risk profile as Newport Beach,
according to the U.S. Geological Survey.16 In fact, Newport Beach experienced some light shaking from
the 2010 Baja California earthquake listed below, but did not incur major unexpected costs to its general
fund.17 Exhibit 4.A.1 lists the events (including magnitude of earthquake, as applicable), estimated
damages18 adjusted for inflation to 2017 dollars, population density at the year of the event, and
estimated damages per capita.
15 See for example, the Rockefeller Foundations “100 Resilient Cities” program, of which GFOA is a partner.
www.100resilientcities.org.
16 U.S. Geological Survey, “Simplified 2014 Hazard Map (PGA, 2% in 50 years),
https://earthquake.usgs.gov/hazards/hazmaps/conterminous/2014/images/HazardMap2014_lg.jpg
17 City of Newport Beach, CA, “Local Hazard Mitigation Plan,” 2016.
18 GFOA estimates the total cost using the typical FEMA reimbursement rate of 75 percent of total cost.
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Exhibit 4.A.1: Estimated Damages from Select California Earthquakes
Estimated
Damages
(2017 $)
Population
Density (year
of event)
Estimated
Damage per
Capita
2003 San Simeon - 6.6 magnitude
Arroyo Grande $30,943 2,849 $11
Atascadero $36,888,800 1,077 $34,248
Morro Bay $380,373 1,960 $194
Pismo Beach $32,552 2,315 $14
San Luis Obispo $9,815 3,464 $3
Guadalupe $948,145 4,975 $191
Santa Maria $52,292 3,855 $14
Subtotal $38,342,920 20,495 $1,871
2010 Baja California - 7.2 magnitude
Brawley $48,205 3,249 $15
Calexico $9,002,756 4,597 $1,958
Calipatria $180,405 2,071 $87
El Centro $2,100,258 3,845 $546
Holtville $3,294,249 5,164 $638
Imperial $695,131 2,518 $276
Subtotal $15,321,004 21,444 $714
2014 South Napa - 6.0 magnitude
American Canyon $71,048 4,229 $17
Calistoga $7,866 2,040 $4
Napa $11,171,809 4,485 $2,491
Yountville $681,714 1,884 $362
Benicia $103,049 2,160 $48
Vallejo $717,781 3,920 $183
Subtotal $12,753,267 18,718 $681
TOTAL $66,417,191 60,657 $1,095
Mean $3,495,642 3,192 $1,095
Median $380,373 3,249 $117
Sources: Federal Emergency Management Agency and U.S. Census Bureau
Compared to the other two earthquakes referenced, the 2010 Baja California earthquake incurred the
lowest damage per capita at $714. However, Calexico’s damages per capita were higher than the other
affected municipalities in the dataset for the event. Atascadero’s damages from the 2003 San Simeon
earthquake are the highest amongst the reference examples and represents an extreme case due to high
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cost of repairing its historic city hall building.19 Due to this and for the purpose of the analysis, we remove
Atascadero from the sample cost per capita and will return to it at the end of this subsection.
Because the estimated damages reflect total cost to the entire municipal government and this analysis
focuses on the general fund only, we need to adjust these figures to make them relevant to the general
fund. We do this by assuming that the general fund’s share of the assets owned by the municipality will
be roughly analogous to the share of damages experienced by the general fund.20 This ratio is shown in
the exhibit below as general fund’s share of total assets. We apply this ratio to the estimated damages
per capita figures shown in Exhibit 4.A.1. Exhibit 4.A.2 lists the estimated general fund damage per
capita.21
To arrive at a general fund reserve recommendation, we first translate the reference cost per capita in
Exhibit 4.A.2 and apply it to Newport Beach’s current population density of 3,641 residents per square
mile. This results in total estimated cost ranging from $6,000 to $7.3 million, which is far too vast to be of
much help in making decisions about Newport Beach’s financial strategy. Therefore, we assume potential
earthquake damage to take the shape of a lognormal distribution, where the City is much more likely to
experience a minor rather than an extreme earthquake.22
19 Creig P. Sherbune, “Financing City Hall: A look at who’s paying the $34 million,” Atascadero News, September 23,
2011, http://www.atascaderonews.com/v2_news_articles.php?heading=0&story_id=4237&page=72.
20 We exclude land since land is not susceptible to earthquake damage in the same way as the built environment.
21 According to Holtville’s FY 2016 CAFR, it does not maintain a complete accounting of capital assets. Thus, the
relative share of capital assets for governmental activities is unavailable and we exclude it from the reference set as
well.
22 GFOA used standard statistical procedures to turn the data from Exhibit 3.A.2 into a lognormal distribution.
A Risk-Based Analysis of General Fund Reserve Requirements for the City of Newport Beach
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Exhibit 4.A.2: Estimated General Fund Damages Per Capita from Select California Earthquakes
General Fund’s Share
of Total Assets
Estimated General Fund
Damage Per Capita
2003 San Simeon - 6.6 magnitude
Arroyo Grande 54% $6
Atascadero 81% $27,581
Morro Bay 51% $99
Pismo Beach 60% $8
San Luis Obispo 48% $1
Guadalupe 42% $81
Santa Maria 63% $9
2010 Baja California - 7.2 magnitude
Brawley 35% $5
Calexico 64% $1,256
Calipatria 57% $50
El Centro 40% $218
Holtville N/A N/A
Imperial 46% $127
2014 South Napa - 6.0 magnitude
American Canyon 82% $14
Calistoga 31% $1
Napa 77% $1,915
Yountville 71% $258
Benicia 51% $25
Vallejo 61% $112
Sources: Federal Emergency Management Agency, U.S. Census Bureau, each cities’ respective CAFR
Exhibit 4.A.3 23 provides a cumulative probability chart of the potential general fund cost the City would
incurred for an earthquake. The horizontal axis represents the percent likelihood of earthquakes covered.
The vertical axis represents the amount of reserves that are required to cover the cost. For example, the
85 percent mark vertical axis intersects with the orange line at a general fund reserve of $1.1 million. As
the graph moves closer to the right, a greater amount in reserves is needed to cover the less probable and
more severe earthquakes. At the top right, as the line changes from blue to orange, we see that the
amount of reserves required to approach 99% confidence is so high that it does not even fit on our chart.
23 Exhibit 3.A.3 does not graph the amount required to cover 99.9% of earthquakes in order to focus on more
probable scenarios. To cover 99.9% of earthquakes would require $380.3 million from the general fund.
A Risk-Based Analysis of General Fund Reserve Requirements for the City of Newport Beach
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Exhibit 4.A.3 - Percent of Earthquake’s Covered by Varying General Fund Reserve Levels
As we move to the right of the graph, the amount Newport Beach needs to reserve to cover the cost
of an earthquake increases. At the top right, as the line color changes to orange, it indicates an
increasing level of reserves to address greater than 95% confidence level.
Of course, the City can be more confident by setting aside more reserves. But to be completely confident,
the City would need to reserve a very high amount, and as we discussed earlier, there are significant
opportunity costs in doing so. Instead, Newport Beach might consider how reserves, debt, and insurance
can work together. First, let us consider establishing some basic principles.
• Reserves make the most sense at the left-hand side of the curve. Here the City gets the most
“bang for the buck” because each extra dollar of reserves buys the greatest increases in
confidence.
• Debt is probably the most useful closer to the middle of the curve. The middle of the curve
represents severe but not catastrophic damage. Here, the City would likely need to fund a
significant response to a disaster but the City’s tax base would not be so impaired (e.g., stores
closed and residents dislocated on a long-term basis) that paying back the debt would be
problematic.
• Insurance is probably most useful closer to the right-hand side of the curve. The right-hand side
of the curve represents catastrophic damage. In this case, the City’s tax base might be impaired
for a significant duration making repayment of debt difficult. Further, the premium payments for
insurance coverage for only a catastrophic event would be less than for coverage that includes
both severe and catastrophic events. Insurance can also complement the City’s risk mitigation
strategy should it decide to reserve an amount closer to the left-hand side of the curve.
Exhibit 4.A.3 shows the “value” the City gets from reserves. Where the curve is flatter, the value of
reserves is high because a relatively modest increase in the size of reserves “buys” a substantial increase
in the confidence the City can have that its reserves will be adequate for an earthquake. Where the curve
$0.0
$1.0
$2.0
$3.0
$4.0
$5.0
$6.0
5%10%15%20%25%30%35%40%45%50%55%60%65%70%75%80%85%90%95%99%
Mi
l
l
i
o
n
s
At 85% confidence level,
the City would require
$1.1 million in reserves.
At 90% confidence level,
the City would require
$2.0 million in reserves.
A Risk-Based Analysis of General Fund Reserve Requirements for the City of Newport Beach
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gets steeper, the City needs to put aside more money to gain less confidence. In Exhibit 4.A.3, we can see
that the “value” provided by reserves starts to decrease significantly after about $1.1 million. For example,
the City can be 80 percent confident of covering the damage from an earthquake at $745,000. It can “buy”
an extra 5 percentage points of confidence to get to 85 percent with a reserve of $850,000 – a difference
of $233,000. By way of comparison, going to 90 percent confidence, requires a reserve of $2.0 million. In
other words, to increase confidence from 85 percent to 90 percent requires nearly doubling the reserve
amount, and to go from 90 to 95 percent requires over two and a half times the reserve. This pattern
suggests the following range for reserves:
• On the low end, $1.1 million. This is the point up to which the curve is flattest. That means it is
where each additional 5 percent of confidence requires an approximately similar increase in
reserves. $1.1 million provides the City with an 85 percent likelihood of being able to cover all
damages from an earthquake with general fund reserves.
• On the high end, $2.0 million. This is the point where the City can be 90 percent confident it could
cover all damages from an earthquake with general fund reserves. It is also the point right before
the curve turns much more sharply upwards, where much greater levels of reserve are necessary
to be more confident.
Choosing a number within the range suggested above will depend on the City’s appetite for risk. In
considering these numbers, we must also remember that the City of Newport Beach itself has not incurred
large costs from an earthquake and that the numbers above are all based on analogues generated from
the experience of other cities. Hence, it is useful to consider how Newport Beach’s vulnerability to
earthquakes might compare to other cities’. First, all of the cities used as analogues in this report have a
similar seismic hazard risk profile to Newport Beach, according to the U.S. Geological Survey. So, the
analogues should be roughly comparable. However, the cities might differ in some of their specific
characteristics that make them more vulnerable or less vulnerable to damages. To gain more insight on
this point, we compared the disaster management plans of different cities in the region to see the
potential earthquake damages that were contemplated for each city.24 We found, for example, that
Newport Beach’s plan contemplated slightly lower damages 25 from an earthquake at the San Andreas
fault, compared to the average for the plans we examined.26 However, we also found that Newport
Beach’s “worst case scenario” from activity along the San Joaquin Hills fault was considered to be more
severe than that of the other cities’.27 As we saw in Exhibit 4.A.3, using reserves for the most severe
24 We reviewed only disaster management plans produced by the same consultant as the consultant used by
Newport Beach for its disaster management plan. The intent was to compare plans that were developed using similar
methodologies and assumptions.
25 Because the disaster management plans do not estimate costs that would be incurred by the municipal
governments themselves in the event of an earthquake, we compared the reports using building-related economic
losses. Building losses include structural and non-structural damage buildings as well as their contents. Income losses
relate to the inability to operate during a period because of damages sustained during a disaster as well as money
spent on temporary living expenses due to displacement. Presumably the costs incurred by the municipal
governments would be proportional.
26 Damages were scaled to population to increase comparability.
27 These plans contemplated damages to the entire community, including private property, overlapping
governments, and more. So, the plans did not offer insight into the potential cost of an earthquake to the municipal
A Risk-Based Analysis of General Fund Reserve Requirements for the City of Newport Beach
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possible earthquake is not economical. Hence, this suggests that the City might wish to give special
consideration to financial risk management strategies for damages in excess of reserves.
For potential damages in excess of the reserve target the City selects, Newport Beach should consider
other financing tools like debt and insurance. The scope of this analysis is limited to general fund reserves,
so GFOA cannot provide more specific guidance on the exact points on the curve in Exhibit 4.A.3 at which
the City should consider debt versus insurance, but we can provide the following recommendations to
help the City develop a more robust strategy:
• Develop a contingent capital arrangement. For damage levels at which the City chooses to use
debt, the City should arrive at pre-arranged terms with a lender to be able to access a loan when
the need arises. This will eliminate the need to negotiate terms during high-stress periods in the
aftermath of an extreme event, and the City will have a much more favorable negotiating position
before an event than immediately after.
• Consider inter-fund borrowing. A loan does not necessarily have to come from an external
creditor. If the City has resources in other funds that are not likely to be compromised by a severe
disaster, the City could use inter-fund borrowing to provide the resources needed by the general
fund. Similar to a contingent capital agreement with an external lender, the City should develop
a robust internal borrowing policy prior to an event to govern the terms of the loan.
• Consider “parametric” insurance in addition to traditional indemnity insurance. Indemnity
insurance is the type of insurance that most governments have traditionally purchased, where
the insurance corresponds to the value of the assets being insured, and reimbursement is paid
out after a certain deductible has been met. The advantage of traditional indemnity insurance is
that there is a known damage threshold past which the City is covered.
Parametric insurance is a newer type of insurance for providing coverage for extreme events,
having increased in popularity in the last 15 years or so. Parametric coverage provides the
policyholder (the City) with a payment amount that is defined ahead of time, should a defined
event come to pass (an earthquake of a certain magnitude). Parametric insurance could be more
useful for providing an injection of liquidity because the holder of the policy receives the defined
payment immediately upon verification by a third party that the given event occurred, which
usually would be within a matter of days. As a simple illustration, a parametric policy might
provide the City of Newport Beach with $5 million upon the occurrence of a 7.0 magnitude
earthquake, after the U.S. Geological Survey verifies the magnitude of the quake. This feature of
parametric insurance also eliminates much of the administrative hassle that would be associated
with a traditional indemnity policy (e.g., working with claims adjusters). A final advantage is that
the proceeds from the policy payout are completely fungible – the City could use them to fund
whatever service it deems necessary whereas indemnity policies might require the policyholder
to use the funds to repair or replace the asset that was insured. But, an important disadvantage
of parametric insurance is that the policy is triggered by the magnitude of the event, not the
damages incurred by the City. So, if the City were to experience a 6.9 magnitude quake, to
continue our previous example, it would receive nothing from a parametric policy regardless of
government. However, it reasonable to assume that the cost to municipal government would be roughly
proportionate to the damage done to the entire community.
A Risk-Based Analysis of General Fund Reserve Requirements for the City of Newport Beach
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the damages it experienced. Additionally, parametric insurance is still a relatively new insurance
instrument, and fewer insurance companies sell parametric policies compared to indemnity
policies.
A robust insurance strategy could make use of both traditional indemnity and parametric
insurance. For example, traditional indemnity insurance could be used to protect against loss of
the City’s assets, while parametric insurance could be used to compensate the City for the losses
in tax revenue it would experience from an impaired tax base, for instance.
As mentioned earlier in this subsection, the estimated damages recorded by Atascadero from the 2003
San Simeon earthquake represent an extreme case. For these extreme events, alternative financing tools
aside from reserves may be prudent. Additionally, Atascadero’s example highlights additional strategies
for Newport Beach to explore. As seen with Atascadero’s city hall, historic buildings are vulnerable when
seismic activity occurs. To help mitigate risk associated with historic buildings, the City could explore
retrofitting, insurance, and other mitigation strategies for buildings that poise the greatest risk as
identified in the City’s disaster management plan.
Earthquake Checkpoints
A severe earthquake is a very low probability event with potentially extreme consequences. This
means that reserves are not a sufficient risk management tool, on their own. This is because there
would be significant opportunity costs to accumulate enough reserves to cover the cost of a severe
earthquake
The City should complement its reserves with debt and/or insurance instruments to provide
additional financial capacity to respond to an extreme event.
A reserve between $1.1 million and $2.0 million should be sufficient to provide the City with 85%
to 90% confidence that it will be able to cover the cost of an earthquake. This is the range of
reserves that is the most “efficient” use of reserves.
Subsection B – Floods (Includes Landslides & Tsunamis)
As a coastal city, Newport Beach faces the risk of flooding from storms, high waves, tsunamis, and rising
sea levels. The Santa Ana River, San Diego Creek, and San Joaquin Hills’ streams can also cause flooding,
with San Diego Creek flooding having caused significant damage to the City.28 The City has experienced
three severe storm and flooding events that were FEMA-declared disasters in December 2004 to January
2005, February 2005, and December 2010 to January 2011.
The three events serve as references to what the City could experience, but to further explore the
possibility of potential damages, we reviewed FEMA’s database for additional severe storms and flooding
in Orange County. Exhibit 4.B.1 lists the cities, estimated damages 29,30 adjusted for inflation to 2017
dollars, population density the year of the event, and estimated damages per capita. Exhibit 4.B.2 adjusts
the estimated damage per capita amounts to focus only the general fund. As with the previous section on
28 City of Newport Beach, “Local Hazard Mitigation Plan,” 2016.
29 GFOA estimates the total cost using the typical FEMA reimbursement rate of 75 percent of total cost.
30 GFOA used figures provided by Newport Beach for two of the events that had differing reimbursement rates from
FEMA to account for reimbursement from California Governor's Office of Emergency Services.
A Risk-Based Analysis of General Fund Reserve Requirements for the City of Newport Beach
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earthquakes, we identify the general fund’s share of capital assets using information from each respective
cities’ most recent comprehensive annual financial report. Doing this allows us to focus on the general
fund, which is the focus of our report. Finally, it should be noted that FEMA’s data groups floods and
landslides together. Hence, the figures used in this section of the report include potential damages from
both types of events.
A Risk-Based Analysis of General Fund Reserve Requirements for the City of Newport Beach
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Exhibit 4.B.1: Estimated Flood Damages in Orange County Cities
Event & Cities
Estimated
Damages
(2017 $)
Population
Density
(year of event)
Estimated
Damage per
Capita
December 2004 to January 2005 Severe Storms and Flooding
Anaheim $3,598,878 6,650 $541
Brea $139,873 3,205 $44
Costa Mesa $165,976 6,967 $24
Dana Point $300,346 5,315 $57
Fullerton $285,815 5,947 $48
Huntington Beach $195,454 7,199 $27
Irvine $370,533 2,722 $136
La Habra $153,089 8,118 $19
Laguna Beach $202,153 2,655 $76
Laguna Niguel $602,195 4,269 $141
Mission Viejo $2,783,161 5,379 $517
Newport Beach $323,705 3,430 $94
San Clemente $162,317 3,329 $49
San Juan Capistrano $1,823,232 2,443 $746
Seal Beach $59,568 2,149 $28
Villa Park $355,940 2,857 $125
Mean $720,140 4,540 $167
February 2005 Storms and Flooding
Anaheim $140,931 6,650 $21
Brea $18,309 3,205 $6
Huntington Beach $95,525 7,199 $13
Laguna Beach $41,707,677 2,655 $15,709
La Habra $7,409 8,118 $1
Mission Viejo $193,583 5,379 $36
Newport Beach* $39,242 3,430 $11
San Juan Capistrano $5,426,949 2,443 $2,221
Santa Ana $78,899 12,207 $6
Mean $47,708,523 51,287 $18,025
December 2010 to January 2011 Winter Storms and Flooding
Aliso Viejo $53,536 6,433 $8
Anaheim $353,016 6,747 $52
Dana Point $169,772 5,131 $33
Fountain Valley $9,326 6,132 $2
Garden Grove $25,406 9,525 $3
Huntington Beach $158,026 7,103 $22
Irvine $101,227 3,212 $32
Laguna Beach $752,198 2,568 $293
Laguna Hills $15,056 4,549 $3
La Habra $10,415 8,174 $1
A Risk-Based Analysis of General Fund Reserve Requirements for the City of Newport Beach
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Lake Forest $199,308 4,336 $46
Mission Viejo $272,051 5,260 $52
Newport Beach* $252,499.05 3,578 $71
Rancho Santa Margarita $102,462 3,692 $28
San Clemente $1,641,417 3,395 $483
San Juan Capistrano $264,001 2,450 $108
Santa Ana $13,379 11,901 $1
Seal Beach $19,902 2,141 $9
Tustin $9,943 6,818 $1
Mean $232,786 5,429 $66
January 2017 Severe Winter Storms and Flooding
Dana Point $16,041.69 5,233 $3
Huntington Beach $69,783.05 7,501 $9
Laguna Beach $60,545.96 2,620 $23
Newport Beach $6,292.03 3,641 $2
Placentia $10,366.21 7,949 $1
San Juan Capistrano $53,170.35 2,569 $21
Santa Ana $109,245.72 12,256 $9
Westminster $11,433.36 9,111 $1
Yorba Linda $228,128 3,503 $65
Mean $62,778 6,043 $15
Reference Group Mean $1,211,674 5,310 $417
Reference Group Median $153,089 5,131 $28
Sources: Federal Emergency Management Agency, U.S. Census Bureau, and City of Newport Beach, CA
* Figure provided by the City, which differs from the FEMA database and may contain reimbursement from California Governor's Office
of Emergency Services.
A Risk-Based Analysis of General Fund Reserve Requirements for the City of Newport Beach
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Exhibit 4.B.2: Estimated General Fund Damages Per Capita from Select California Floods
Event & Cities General Fund Share
of Capital Assets
Estimated GF
Damage Per Capita
Anaheim 32% $173
Brea 64% $28
Costa Mesa 100% $24
Dana Point 100% $57
Fullerton 78% $38
Huntington Beach 72% $20
Irvine 100% $136
La Habra 66% $12
Laguna Beach 66% $50
Laguna Niguel 100% $141
Mission Viejo 99% $510
Newport Beach 78% $74
San Clemente 51% $25
San Juan Capistrano 42% $311
Seal Beach 59% $16
Villa Park 100% $125
February 2005 Storms and Flooding
Anaheim 32% $7
Brea 64% $4
Huntington Beach 72% $10
Laguna Beach 66% $10,326
La Habra 66% $1
Mission Viejo 99% $35
Newport Beach* 78% $9
San Juan Capistrano 42% $927
Santa Ana 80% $5
December 2010 to January 2011 Winter Storms and Flooding
Aliso Viejo 100% $8
Anaheim 32% $17
Dana Point 100% $33
Fountain Valley 50% $1
Garden Grove 61% $2
Huntington Beach 72% $16
Irvine 100% $32
Laguna Beach 66% $193
Laguna Hills 88% $3
La Habra 66% $1
Lake Forest 100% $46
Mission Viejo 99% $51
Newport Beach 78% $55
A Risk-Based Analysis of General Fund Reserve Requirements for the City of Newport Beach
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Rancho Santa Margarita 100% $28
San Clemente 51% $246
San Juan Capistrano 42% $45
Santa Ana 80% $1
Seal Beach 59% $5
Tustin 87% $1
January 2017 Severe Winter Storms and Flooding
Dana Point 100% $3
Huntington Beach 72% $7
Laguna Beach 66% $15
Newport Beach 78% $1
Placentia 78% $1
San Juan Capistrano 42% $9
Santa Ana 80% $7
Westminster 86% $1
Yorba Linda 90% $58
Sources: Federal Emergency Management Agency, U.S. Census Bureau, each cities’ respective CAFR
The estimated general fund damages range greatly for the over 50 reference examples, but there are
more instances of lower cost damages than higher cost damages. At the lower end, there were several
cities that recorded under $1 per capita in general fund damages, including La Habra for the February
2005 storms and flooding, La Habra, Santa Ana, and Tustin for the December to January 2011 winter
storms and flooding, and Placentia and Westminster for the January 2017 severe winter storms and
flooding. Consecutive days of rain resulted in large damages recorded for the February 2005 storms and
flooding disaster. At the higher end, Laguna Beach recorded $10,300 in general fund damages per capita,
followed by San Juan Capistrano at $927. The volume of rain left Laguna Beach’s soil saturated, which
resulted in a landslide the following May.31 Significant rain in San Juan Capistrano almost compromised
the levee at San Juan Creek and improvements have been underway since to mitigate the creek’s flooding
risk.32 This pattern of many smaller floods and few very large ones suggests a lognormal distribution, like
we used for earthquakes.
As with the earthquake analysis, to make the reference cases more applicable to Newport Beach, we apply
each reference’s general fund cost per capita to the City’s current population density of 3,641 residents
per square mile. The lognormal distribution of the referenced floods is shown in Exhibit 4.B.3.33 The
horizontal axis represents the percent of floods that should be covered by the amount of general fund
reserves shown on the vertical axis.
31 U.S. Department of Commerce, National Oceanic and Atmospheric Administration, “A History of Significant
Weather Events in Southern California,” updated May 2017,
https://www.weather.gov/media/sgx/documents/weatherhistory.pdf.
32 Orange County, CA Public Works, “Background Information,”
http://www.ocflood.com/nfc/projects_a/sjc/background.
33 Exhibit 4.B.3 does not graph the amount required to cover 99.9% of floods in order to focus on more probable
scenarios. To cover 99.9% of floods would require $41.5 million.
A Risk-Based Analysis of General Fund Reserve Requirements for the City of Newport Beach
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As the line changes from blue to orange, it
represents the increasing amount of reserves
that are required beyond the 95 percent
confidence level. Note, as stated earlier, these
figures represent total estimated cost of floods
in 2017 dollars, exclusive of any FEMA
reimbursement. For example, if the City wants
to cover 75 percent of possible flood events, it
would reserve an amount of $217,000. As we
move to the right, we see that it requires
greater reserves to cover each additional 5
percent of floods. To cover 90 percent of floods
would require $652,000, over twice as much
that is required to cover 75 percent of floods.
This is because the right hand side of the graph
represents increasingly extreme and, therefore,
increasingly unlikely possible future floods. In order to cover the most extreme floods (those above our
95th percentile), the City might consider other strategies besides general fund reserves because of the
high cost of covering additional flood possibilities. Examples of such strategies might be loans and
insurance.
Exhibit 4.B.3 - Percent of Floods Covered by Varying Reserve Levels5
To cover 75% of floods, the City would reserve $217,000.
34 State of California Governor’s Office of Emergency Management, “2013 California Multi-Hazard Mitigation Plan,”
Chapter 6 - Other Hazards: Risks And Mitigation, http://www.caloes.ca.gov/for-individuals-families/hazard-
mitigation-planning/state-hazard-mitigation-plan.
$0.0
$0.2
$0.4
$0.6
$0.8
$1.0
$1.2
$1.4
$1.6
$1.8
$2.0
5%10%15%20%25%30%35%40%45%50%55%60%65%70%75%80%85%90%95%99%
Mi
l
l
i
o
n
s
At 75% confidence level, the
City would need a reserve of
$217,000.
At 90% confidence level,
the City would need a
reserve of $652,000.
The Risk of Tsunamis
A tsunami is a tidal wave caused by the displacement
of a large body of water. Multiple kinds of geological
events could cause a tsunami, such as an earthquake
or volcano. FEMA has recorded only one tsunami
causing damage to California cities. Due to a 2011
tsunami, three cities incurred damages, ranging from
about $7,000 to $104,000 (for the entire city
government, not just general fund). Of course, many
other tsunamis have landed on California: over 80 in
the last 150 years.34 Although this data set is limited,
it does appear that most tsunamis would cause
damage that is roughly comparable to other types of
flooding Newport Beach might experience.
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So, to summarize a recommended reserve range:
• On the low end, $217,000. This is the 75 percent confidence level and is the point at which the
City will get the most value from reserves. After this point, each additional 5 percentage points of
confidence requires over 1.3 times the amount of reserve. We can consider this a less risk averse
reserve strategy.
• On the high end, $652,000. This is the 90 percent confidence level. At this point, over two times
as much reserves are required as at the 75% confidence level. This might be considered a more
risk averse approach.
When selecting a reserve target, the City might also take into account its current flood mitigation efforts,
including infrastructure improvements to flood walls, etc.35 Such mitigation efforts might prevent some
floods from occurring at all and/or lessen the impact.
Flood Checkpoints
Floods are similar to earthquakes in that they are rare events with potentially extreme
consequences.
Newport Beach has experienced three floods in its recent history, giving us some useful past
experience to draw upon to estimate future risk. We supplemented this with the experience of
other cities in the region.
A reserve between $217,000 and $652,000 should be sufficient to provide the City with 75% to 90%
confidence that it will be able to cover the cost of a flood. This is the range of reserves that is the
most “efficient” use of reserves.
Subsection C – Fires
The City of Newport Beach is vulnerable to fires because of the area’s weather, topography, and
vegetation. In the past, the City and surrounding areas have experienced fires, with the most severe in
recent years affecting nearby Laguna Beach in 1993.36 The City’s primary risk from wildfires arises from its
proximity to Crystal Cove State Park. In recent years, fortunately, the City has not experienced fires for
which it incurred damages. Also, nearby cities with comparable risk of wildfire have not experienced many
fires either. So, rather than draw from analogues as with other extreme events, we worked with the City’s
Fire Chief to estimate the potential cost the City could incur for a fire. According to the Fire Chief, most
fires last about four to six hours, with the maximum duration being approximately 12 hours. This is simply
because there is not enough vegetation in Newport Beach to cause a large-scale fire.
If the City were to experience a fire, it can contract with the County as well as the State of California Office
of Emergency Services through an assistance-by-hire agreement to help address the fire. The table below
provides a summary of items needed and estimates from City’s Fire Chief on the number of units needed
for each item to fight a 4-hour and 12-hour fire. Each unit would be required for the full duration of the
fire. The table also includes the hourly rate per the assistance-by hire-agreement. This allows us to
calculate the total estimated cost for a 4-hour and 12-hour fire.
35 City of Newport Beach, CA, “Local Hazard Mitigation Plan,” 2016.
36 City of Newport Beach, CA, “Local Hazard Mitigation Plan,” updated 2016.
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A Risk-Based Analysis of General Fund Reserve Requirements for the City of Newport Beach
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Exhibit 3.C.1: Estimated Cost of 4-Hour and 12-Hour Fire to City of Newport Beach
# of Units Needed Total Cost
Item
4-hour
fire
12-hour
fire
Hourly
Rate
4-hour
fire
12-hour
fire
Hand Crew (Firefighter) 18.00 36.00 $36.84 $2,652 $15,915
Hand Crew Supervisor (Fire Captain) 1.00 2.00 $71.56 $286 $1,717
Hand Crew Supervisor (Fire App. Engineer) 1.00 2.00 $62.77 $251 $1,506
Hand Crew Supervisor (Firefighter) 1.00 1.00 $55.97 $224 $672
Heavy Fire Equipment Operator 1.00 1.00 $96.11 $384 $1,153
Fire Pilot 1.00 2.00 $73.49 $294 $1,764
Lead Fire Pilot 1.00 1.00 $84.50 $338 $1,014
Type 3 Engine 2.00 2.00 $80.00 $640 $1,920
Crew Carrying Vehicle 1.00 2.00 $21.75 $87 $522
Dozer Transport 1.00 1.00 $73.25 $293 $879
Dozer 1.00 1.00 $72.50 $290 $870
Dozer Trailer 1.00 1.00 $14.00 $56 $168
Dozer Tender 1.00 1.00 $26.00 $104 $312
Fuel Tender 1.00 1.00 $36.75 $147 $441
Patrol Unit (Type 6) 1.00 3.00 $80.00 $320 $2,880
Water Tender 1.00 1.00 $36.75 $147 $441
Helicopter - Bell Super Huey 1.00 1.00 $1,329.74 $5,319 $15,957
Helicopter - Bell 412 1.00 1.00 $4,191.13 $16,765 $50,294
Total $28,598 $98,425
The potential cost that the City could incur is not as simple as a range between $28,600 and $98,400. This
is because there is uncertainty that a fire might cost less or more than these estimated figures. In fact,
research shows that when people estimate a range of possibilities for an uncertain event, they usually
make the range too narrow. In other words, they underestimate the amount of risk.37 This is not a failure
in judgment – it is just the way in which the human mind works. After all, if people were able to accurately
judge risk, we would not need projects like the one GFOA is performing for Newport Beach. In fact, GFOA
had the opportunity to validate this proposition at another local government. We asked the fire chief in
that jurisdiction to estimate variability in fire size and then compared the cost to data from actual fires we
collected from the region. We found that the chief underestimated the variability in fire size in a manner
very similar to how research suggests people routinely underestimate uncertainty.
This does not mean that the figures in Exhibit 3.C.1 are not helpful – to the contrary, they provide an
excellent starting point which we can transform into a probabilistic distribution. We created a distribution
that extends the tails of the distribution beyond the range suggested by Exhibit 3.C.1. We set the size of
the tails by doubling the size of the range from Exhibit 3.C.1. Research suggests that human judges
37 Jack Soll and Joshua Klayman (2004). “Over-confidence in Interval Estimates”. Journal of Experimental Psychology:
Learning Memory and Cognition. 30, pages 299-314.
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typically underestimate uncertainty by about 50%. Doubling the range compensates for this. Exhibit 3.C.2
shows the resulting probabilistic cumulative probability chart of fire cost.
Exhibit 3.C.2 – Confidence that Wild Fire Cost will be Covered by Reserves
The incremental cost to cover fires increases at the 85th percentile or when reserve reach $118,500.
The horizontal axis shows the confidence a given reserve will cover the cost of a fire. The vertical axis
shows the amount of reserves. As the line moves from left to right, we see cost increasing and the color
change from blue to orange to reflect greater uncertainty to cover closer to 100% of fires. Up until the
85th percentile, each additional 5 percent incremental coverage of fires will require about 10% more
reserves. The cost then increases to about 20% more reserves by the 95th percentile and to 35% more by
the 99th percentile. Here is the range in between which reserves are most “efficient”:
• Reserve $118,500 to cover 85% of fires as a less risk-averse approach. This represents the point
on the graph where the City maintains maximum incremental coverage through reserves.
• Reserve $159,000 to cover 95% of fires as a more risk-averse approach. This is where the City
would get greater coverage through reserves before the incremental cost noticeably increases.
Newport Beach also benefits from a strong mutual aid system among the local governments in the region.
Newport Beach also undertakes fire prevention programs, training, vegetation management, and other
related activities to lessen the impact of wildfires in the area. This helps manage the fire risk that the City
is subject to from fires and complements the City’s reserve strategy.
Fire Checkpoints
The City has not experienced a wildfire in many years. This means there is no useful historical data
to draw upon. Therefore, we worked with the City’s Fire Chief to estimate a range of potential costs.
We used statistical techniques to widen the range we developed with the Fire Chief. This was
intended to compensate for the natural human tendency to underestimate future uncertainty.
A reserve between $118,500 and $159,000 should be sufficient to give the City 85% to 95%
confidence that it could cover the cost of a wildfire. This is the most “efficient” use of reserves.
$0
$25,000
$50,000
$75,000
$100,000
$125,000
$150,000
$175,000
$200,000
$225,000
$250,000
5%10%15%20%25%30%35%40%45%50%55%60%65%70%75%80%85%90%95%99%
At 95% confidence level,
the City would need a
reserve of $159,000.
At 85% confidence level,
the City would need a
reserve of $118,500.
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Subsection D – High Winds
Newport Beach is subject to high winds on a regular basis, but the damages are not as potentially severe
as for the other risks we have examined. Hence, high winds is a higher frequency, lower consequence
event compared to the others we have examined so far. For our analysis, we assumed that the City would
be exposed to some costs to respond to high winds every year. We found damages have ranged between
$60,000 and $140,000 per year. However, we only had a few years’ worth of data to consult. Hence, we
doubled the range of potential damages. Doubling a range that is based on little data is a rule of thumb
for approximating the range in which 95% of future events should fall.38
We assumed that the City’s regular budget was capable of absorbing the damage from an “average” year,
or about $100,000. Therefore, reserves would only be necessary for wind damages that were beyond
what happens in an average year. Exhibit 3.D.1 shows the reserves the City would need for a given level
of confidence. The City wouldn’t need any reserves for about 50% confidence and below, because wind
damages up to that point would be covered by the regular City budget. The required reserves increases
rapidly after that. 95% confidence would require about $86,000.
Exhibit 3.D.1 – Reserves Required for High Winds Damage (in thousands of dollars)
Reserves
(thousands
of dollars)
Level of Confidence
High Wind Checkpoints
High winds are a high frequency, lower consequence event.
The City’s budget can absorb lower wind damages. Reserves can help with higher damages.
$86,000 would give the City 95% confidence of being able to cover the costs of a high wind event.
38 See: Spyros Makridakis, Robin Hogarth, and Anil Gaba. Dance with Chance: Making Luck Work for You. (Oneworld
Publications: Oxford, England). 2009.
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Section 5 - Revenue Volatility
An important risk for any local government is revenue volatility, primarily owing to downturns in the
economy. For example, Newport Beach’s revenue declined about 9% from fiscal year (FY) 2008 to FY 2010
due to the Great Recession. Reserves can be used
to help a local government make a “soft landing”
in the event of a revenue downturn.
In this section of the report, we will analyze the
City’s vulnerability to revenue downturns. In
Newport Beach, property taxes are, by far, the
single most important revenue source at about
half of general fund revenues. Sales taxes are the
second most important at about 15%. Transient
occupancy taxes are the third largest at about 12%.
The remaining revenues comprise about a quarter
of general fund revenues and include sources such
as building permits and business licenses. Exhibit
5.1 summarizes the City’s general fund revenue
portfolio between FY 2013 and FY 2017.
In the subsections below, we will examine each of the major revenues. The objective is to determine if
the composition of the revenue base has changed such that the City of Newport Beach is more vulnerable
or less vulnerable to revenue downturns than in the past. This is important because in the last section we
will use the City’s historical revenue data to analyze risk to the revenue portfolio as a whole.
Subsection A - Property Taxes
In addition to being the largest revenue source, property taxes are also the most stable. While general
fund revenues declined 9% from FY 2008 to FY 2010, property tax
revenues increased by 1.5%. Exhibit 5.A.1 compares the change in
property tax to the changes to the City’s other revenue sources
during this period.
The most obvious reason for the property tax’s strength is that
Newport Beach is a very desirable locale, next to the Pacific
Ocean. For example, when it comes to home values, Newport
Beach is in the top five to six percent of California cities.40 Also,
Newport Beach is in the top third of California cities where the average home value has now met or
exceeded 2007-08 highs.41
39 Percentages are based on an average of fiscal years 2013 through 2017.
40 According to Zillow’s average home valuation database, Newport Beach has 40th highest average home value out
of the 719 California cities included in their database.
41 According to Zillow’s average home valuation database.
Exhibit 5.1 – Composition of Newport Beach’s
General Fund Revenue Portfolio 39
Property taxes, are by far, the most important
revenue source
Exhibit 5.A.1 – Change in Revenues,
FY 2008 to FY 2010
Property Taxes 1.5%
Sales Taxes -20.2%
Transient Occupancy Tax -11.7%
Other -19.2%
Total -9.2%
0.0%20.0%40.0%60.0%
Property Taxes
Sales Taxes
Transient Occupancy
Tax
Other
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Another strength of the City of Newport Beach’s property tax base is the composition of its largest
taxpayers. For example, some cities have a few taxpayers that constitute a very large proportion of the
total tax base. This presents a risk if those taxpayers cease to do business in the locale. The prototypical
example would be a large manufacturing plant in an industry that is undergoing significant structural
changes. In Newport Beach, the largest property taxpayer is The Irvine Company, which accounts for
about 2.87% of the total taxable assessed value in the City. The Irvine Company buys and holds real estate.
Hence, even if the Irvine Company ran into financial difficulties, it seems unlikely that its real estate assets
would lose much, if any, value. Past The Irvine Company, the next largest property taxpayer, PH Finance
LLC, constitutes only 0.53% of the City’s total taxable assessed value and the share of the tax base
attributable the largest taxpayers declines from there: the 10th largest, John Hancock Life Insurance,
comprises 0.21% of the total taxable value. So, as demonstrated above, the largest property taxpayers in
Newport Beach do not comprise an overwhelming portion of the tax base. Further, the nature of their
holdings do not seem to pose a risk of precipitous declines in value due to changing business conditions
because they are not concentrated in a potentially vulnerable sector of the economy.
According to City staff, most of the property development activity that is taking place in Newport Beach
is infill development, turnover of property, and significant remodeling of existing properties. There could
also be occasional appeals of assessed values, if the property market gets overheated. However, none of
these factors seem capable of introducing enough volatility into property tax revenues to change the tax’s
traditional role of imparting stability to the City’s revenues.
Property Tax Checkpoints
Property tax is the City’s largest revenue source.
Property tax revenues did not decline at all during the Great Recession. Hence, it has a stabilizing
influence on City revenues.
The City’s tax base is diverse. This is a source of stability.
Subsection B - Sales Taxes
As we saw in Exhibit 5.A.1, sales taxes experienced the greatest decline during the Great Recession. For
many cities, sales taxes are a volatile revenue that are vulnerable to economic downturns. To gain better
insight into sales tax volatility, we can break down Newport Beach’s tax base by type of tax producer. The
data available to GFOA from the City’s contracted sales tax analyst, HdL, breaks sales taxes down into
eight categories of sales tax producers. Three of those categories produce just over 70% of the City’s
revenues: autos and transportation (30%), restaurants and hotels (22%), and general consumer goods
(20%). Exhibit 5.B.1 shows the three major categories of sales taxes.42 It also includes all other locally
produced sales taxes as the “other” line. Finally, county and state pools are shown as a separate line.
42 This data is expressed in calendar years, rather than fiscal years.
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Exhibit 5.B.1 – City Sales Taxes by Category of Tax Producer (in millions)
Restaurants and hotels have overtaken general consumer goods as a portion of the tax base. The
former is a more stable producer.
In Exhibit 5.B.1, we can see that all categories declined during 2008 through 2010, though some more
than others. General consumer goods experienced the sharpest decline at 24%. Autos and transportation
was second at 19%. A 19% decline was not too much more than the declines experienced by the “county
and state pools” or “other” categories. However, the size of autos and transportation category makes a
19% decline more impactful. The restaurants and hotels category was barely effected by the Great
Recession as evidenced by its 5% decline.
Turning our attention to the recovery from the Great Recession, we can see that autos and transportation
recovered well. In fact, it now produces a slightly higher share of all sales taxes than it did before the Great
Recession. Since restaurants and hotels did not fall far, the segment recovered quickly and continued to
grow. General consumer goods, however, has not recovered to pre-recession levels and has even declined
in recent years. In fact, it fell behind restaurants and hotels in importance as a sales tax producer. This is
probably not too surprising given the pressure that traditional retailer have faced from on-line retail. The
“other” and county and state pool categories recovered well. The “other” category includes business and
industry taxes, which were very volatile during the Great Recession. These taxes dropped sharply and
recovered sharply. The “other” category also includes consumer essentials, like food and fuel that didn’t
change much during the Great Recession. Hence, these sub-categories balanced each other out to some
extent, thereby preventing the “other” category from exhibiting dramatic behavior.
The implication is that the sales tax base does not appear to be any more vulnerable to recessions than it
has been in the past. In fact, the sales tax base might now be somewhat less vulnerable because general
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consumer goods has been overtaken by restaurants and hotels as a major sales tax producer. The latter
category proved more resistant to economic downturns during the Great Recession. Further, Newport
Beach now participates in a County sales tax pool for on-line sales, which does offset at least some
potential future loss of brink-and-mortar stores to on-line sales.
Sales Tax Checkpoints
Sales tax is a volatile revenue. During the Great Recession, it had the sharpest decline of any of
the City’s major revenue sources.
Since the Great Recession, restaurants and hotels have superseded general consumer goods in
importance as a source of sales tax revenue. The former appears to be a much more reliable
producer during economic downturns. This means that the City’s sales tax revenues may be more
stable than in the past.
Subsection C - Transient Occupancy Taxes
The transient occupancy tax (TOT) is essentially the City’s hotel bed tax. Exhibit 5.A.1 shows that TOT can
be vulnerable to economic downturns, but perhaps not as volatile as other revenue sources. In Newport
Beach, the top five TOT-producing hotels make up over 60% of the City’s total TOT revenue. The Resort at
Pelican Hill is particularly important at over a quarter of TOT revenue. Hence, this means the City is
theoretically vulnerable to a business interruption at one of the key hotels.
Of course, it is in the financial interest of the hotels to be at peak capacity as much as possible and, since
2008, the TOT revenue produced has been up across all properties. This appears to be due to steadily
rising room rates, while maintaining a consistent level of occupancy. Between calendar year 2010 and
2017, the average daily hotel room rate is up 54%, while occupancy rates are up only 13%.43 This has
contributed to a doubling of TOT revenues between 2009 and 2017.44 The City’s long-term forecasting
consultant, Beacon Economics, expects this upward trend to continue. In fact, for the period of FY 2017
through FY 2022, Beacon predicts that TOT will grow 25% more than property tax and 50% more than
sales tax.45 Hence, it would appear that the hotel sector in the City is fundamentally healthy.
The foregoing suggests that a general economic downturn is probably the most significant risk to TOT
revenues. Given the continuing, if not increasing, strength of Newport Beach’s hotel sector, TOT does not
appear to be any more vulnerable to a downturn than it has been in the past.
Earlier, we mentioned that a business interruption to a large hotel might be a theoretical risk given that
larger hotels produce the lion’s share of TOT revenue. For example, a fire at one of the major hotels that
makes the hotel unoccupiable could cause a drop in revenues at that hotel. However, given that the hotel
operator would have a clear incentive to put the rooms back in service as soon as possible and given that
other hotels in Newport Beach would likely be able to pick up excess demand,46 this risk does not appear
43 “2016 – 2017 Newport Beach and Company Annual Report: Go Beyond”. New Beach & Company.
44 The City also added some rooms during this time period.
45 “City of Newport Beach Revenue Forecast” Beacon Economics. January 2017.
46 The occupancy rate in Newport Beach hotels is around 75%. The City’s occupancy reports suggests that Newport
Beach hotels typically experience and occupancy rate that is close to the Orange County average, so are not
especially overcrowded compared to other hotels in the region.
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to be large and would certainly be absorbable within a reserve that is sufficient to cover an economic
downturn.
Transient Occupancy Tax Checkpoints
TOT is Newport Beach’s fastest growing major revenue source.
TOT is vulnerable to economic downturns, but not as vulnerable as sales taxes or many other
minor City revenue sources.
The hotel industry appears strong in Newport Beach, given steady rising room rates and stable
occupancy. Hence, it does not appear that the TOT is much more vulnerable to an economic
downturn than before.
Subsection D - Other Revenues
When considered together, the City’s other revenue sources are larger than both TOT and sales taxes.
They also can be vulnerable to economic downturns, as we saw in Exhibit 5.A.1. In fact, the decline in
other revenues was only slightly less than the decline in sales taxes. As of FY 2017, the top five most
important individual revenue sources within the other category are business license taxes, paramedic
service fees, building permits, plan checking fees, and cable franchise fees. However, these sources only
produced about 30% of other revenue. Newport Beach, in FY 2017, had almost 100 individual revenue
sources that produced over $100,000 and 15 sources that produced over $1 million. This shows the
diversity of these revenues.
Comparing the individual sources that make up other revenues between the Great Recession and FY 2017,
we can see that there have been some changes that would decrease potential volatility. For example,
investment income was an important revenue at the start of the Great Recession and declined
precipitously. Investment income does not break into the top ten other revenues in FY 2017. The top two
other revenues in FY 2017 are business license taxes and paramedic service fees, both of which proved
much more resistant to the economic downturn than most other revenues. Cable franchise fees and
parking fines are also both important revenues in FY 2017 (as they were before) and proved more resistant
to the downturn than most other revenues.
There have also been a few changes that might increase vulnerability. Building permits and plan checking
fees are now more important than they had been at the start of the Great Recession and both
demonstrated higher-than-average vulnerability to the downturn. However, the changes that could
increase vulnerability should be at least balanced out by the changes that decrease vulnerability.
Other Revenue Checkpoints
During the Great Recession, “other revenues” declined only slightly less than sales taxes, the
City’s most volatile revenue.
Since the Great Recession, the composition of “other revenues” has changed somewhat. Some
less volatile revenues have gained more prominence. However, some volatile revenues are still
important. Overall, “other revenues” should be at least as stable, if not more stable, than in the
past.
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Subsection E - Risk Analysis of All City Revenues
To analyze the risk that an economic downturn poses to the City’s revenues we will start with the City’s
historical experience with past downturns. Earlier, we discussed some of the year-to-year changes in the
City’ revenues during the Great Recession. However, in order to make the best use of the City’s data for
risk analysis we need to use monthly and/or quarterly data. Monthly or quarterly data will give us a more
precise estimate of how long the revenue downturn lasted. Annual revenue figures are essentially an
average of all 12 months. However, if, for example, three of those months are part of an economic
downturn and nine are part of the subsequent recovery, then the year as a whole will show revenue
growth. This could cause us to underestimate the length of time City revenues are negatively impacted by
an economic downturn.
In order to make the best use of monthly/quarterly data for risk analysis, we need to remove the effects
of what is known as “seasonal” variation. This means that there is some regularly occurring variance in
the revenue that is independent from economic cycles. For instance, in Newport Beach, the final months
of the calendar year always provides the most sales tax revenue, presumably due to holiday spending. So,
if those months produce more revenue than the City was generating during the preceding fall months,
that does not necessarily mean that an economic downturn has ended – it could just indicate seasonal
variation. A simple way to remove season variation is to create a 12-month moving average. This means
that for every single month in our data set we take an average consisting of that month plus the six months
prior and the five months after (for a total of 12 months). This essentially averages out annual seasonal
variation and gives us a purer sense of the impact of economic cycles on Newport Beach’s revenue.
In Exhibit 5.E.1 monthly revenues are plotted out from December 1998 to December 2016. The blue line
represents the 12-month moving average, while the red line is actual monthly revenues. We can see that
the red lines exhibit large swings during the year such that it is hard to pick out when there is an economic
downturn. The blue line removes seasonal effects, which results in a much smoother line. We can see the
economic downturns much more easily – which are highlighted by the green circles. The Great Recession
is the right-hand circle and revenues declined by about 13% from the high just before the downturn
started to the point at which revenues turned back upwards.
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Exhibit 5.E.1 – Monthly Revenues for the City of Newport Beach
The Great Recession had a much more noticiable impact on City revenues.
The length of the downward trending blue line associate with the 2001 Dot.Bomb recession is 16 months.
The length of the downward trending blue line associated with the Great Recession is 21 months.
According to the Bureau of Economic Analysis, the duration of the 2001 Dot.Bomb recession was eight
months while the length of the Great Recession was 18 months. Hence, it appears that the City’s revenue
portfolio will be depressed by an economic downturn for longer than economists’ measurements of the
length of that downturn might suggest. We will take this into consideration when analyzing the risk that
the City is subject to.
We can also see from Exhibit 5.E.1 that the Great Recession resulted in a steeper decline in revenues.
From March 2008 to January 2010, the moving average of City revenues declined 14.7%. In contrast, from
February 2001 to May 2002, the moving average only declined 4.4%. Because the Great Recession was
both deeper and lengthier, we will use that as our primary reference case for determining possible future
risk. A reserve calibrated against the Great Recession will prove sufficient for a lesser recession, like the
2001 Dot.Bomb recession.
To analyze the variability of the City’s revenue and risk, we used quarterly data. We first measured all of
the quarterly changes in revenue during the Great Recession period circled on Exhibit 5.E.1, where a
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“quarter” was any consecutive three-month period (we did not limit ourselves to calendar year quarters).
This gave us a sample of plausible changes in revenue during a hypothetical future recession. We found
that the average quarterly change in revenue was a decline of 0.9%. We also found that changes were
roughly normally distributed around this average, meaning they took the approximate shape of the “bell
curve” that we introduced at the beginning of this report. We then were able to simulate potential
revenue declines over multiple subsequent quarters. For example, we found that for a hypothetical 4-
quarter recession there was only a 1% chance of a decline in revenue of 14.95% or more and a 10% chance
of a decline of 10.53% or more. This gave us the probable depth of a recession for every quarter in a
hypothetical future recession.
The next step was to define the likelihood of different potential lengths of future recession. To do so, we
gathered data on the lengths of all recessions that occurred in the U.S. since 1950. However, we also
found that Newport Beach’s revenue downturns had lasted longer than both the 2001 Recession and
Great Recession, by about three to four months. Hence, we assumed that Newport Beach’s revenues
would also experience a one-quarter longer downturn in future recessions. With this in mind, we found
the average length of a recession was four and 1/3 quarters. However, the lengths of the recessions were
not normally distributed around this average. The shape was closer to the “lognormal” distribution we
saw earlier in this report, where shorter recessions were more likely and very long recessions unlikely.
This gave use the probable length of a hypothetical future recession.
By combining length and depth, we can get the amount of reserves that Newport Beach would need to
be prepared for a hypothetical future recession. The results are shown in Exhibit 5.E.2. The vertical axis
shows various possible reserve levels, expressed as a percent of revenues. The horizontal axis shows how
confident the City would be that a given level of reserves could replace 100% of the City’s revenue decline
during a hypothetical future recession. First, let’s review a few points of interest about Exhibit 5.E.2:
• The exhibit does not call out specific recession lengths or depths because they are all combined
on the blue line. For example, a recession that would require a 10% fund balance to replace all
revenue could be a product of shorter but a deeper recession or a longer but shallower recession.
The point on the line that intersects with the 10% reserve reflects all such possibilities.
• It is unlikely that the City would replace every last dollar of lost revenue with reserves during an
actual recession. Rather, it would cut some spending. Hence, GFOA’s recommendations can be
adjusted downward according to how much the City feels it could cut from its budget. We will
reflect the possibility for downward adjustment in Section 7 of this report.
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Exhibit 5.E.2 – Reserves Required to Replace Revenues Lost During a Recession
Reserves
as a % of
Revenue
Confidence that reserves will remain above $0 during a future Recession
Around 70% confidence provides the best “value” reserve level. Above 90% confidence, the value of
additional reserves declines rapidly.
In Exhibit 5.E.2, the point at which the City gets the most “value” for its reserve is about 70% confidence
or a reserve of 8.0% of revenues. Past this point, it costs proportionately more money to “buy” an extra 5
percentage points of confidence. To illustrate, to go from 65% confidence to 70% confidence the reserve
must go from 7.4% to 8.0%. But, to go from 70% confidence to 75% confidence the reserve must go from
8.0% to 8.8%. To go from 75% to 80% confidence requires 9.6% reserves. Past 90% confidence, the curve
becomes even steeper, making additional confidence even more “expensive.”
Hence, the City of Newport Beach might consider a range of possible reserves to guard against revenues
declined from an economic downturn. Recall that earlier in this report we saw that the City’s revenue
sources do not appear to be any more vulnerable to an economic downturn than they have been in the
past. This means the numbers below, which are based on historical data, should provide a reasonable
representation of current risk. If anything, they may be somewhat conservative given that some of
Newport Beach’s revenues may now be less vulnerable to downturns than in the past. As a point of
reference, at their lowest point, the City’s quarterly revenues declined about 10% from their highs right
before the Great Recession.
• Low end: A reserve equal to 8.0% of revenue, giving the City 70% confidence of being able to
replace 100% of all revenue lost from a recession. Assuming annual revenues of about $205
million, this translates to a reserve of about $16.4 million.
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• High end: A reserve equal to 12.0% of revenue, giving the City a 90% chance of being able to
replace 100% of all revenue lost from a recession. Assuming annual revenues of about $205
million, this translates to a reserve of about $24.6 million.
Again, it should be noted that the City would probably not want to replace every last dollar of lost revenue
with reserves during an actual recession. Rather, it would cut some spending. Hence, GFOA’s
recommendations can be adjusted downward according to how much the City feels it could cut from its
budget. We will reflect the possibility for downward adjustment in Section 7 of this report.
Revenue Risk Analysis Checkpoints
GFOA used Newport Beach’s historical experiences with the Great Recession, 2001 Dot.Bomb
recession, and recession records since World War II to simulate the impact of a hypothetical
future recession.
The simulation found that a reserve equal to 8.0% of revenue (or about $16.4 million) would
give the City 70% confidence of being able to replace 100% of all revenue lost from a
recession. This represents a potential lower bound for the City’s reserve target because it is
the point at which reserves provide the best “value” for the money.
The simulation found that a reserve equal to 12.0% of revenue (or about $24.6 million) would
give the City a 90% chance of being able to replace 100% of all revenue lost from a recession.
Beyond this point, it gets much more “expensive” for the City to gain more confidence with
larger reserves.
The City may not wish to replace 100% of all lost revenue during a recession. It might also
wish to cut back expenditures. The City can adjust GFOA’s recommended reserve levels
downward in accordance with its willingness to cut spending during a recession.
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Section 6 - Secondary Risks
This section of the report addresses other risk factors that have less weighty implications for the City’s
reserve strategy than those described in the previous sections. These include pensions; non-pension debt;
expenditure spikes; liquidity; future growth; and existing claims on the City’s fund balance.
Subsection A - Pensions
Like many cities in California, Newport Beach faces a substantial pension liability. The City has been
forward-thinking in developing and following a plan to fund its pension liabilities. For the purposes of this
report, we will examine one specific pension scenario: the impact of a recession.47 This is because the
purpose of reserves is to buffer the City against shocks. A recession is a shock. The City’s normal, on-going
pension liability is a known and predictable financial stressor that should be dealt with through the City’s
normal budgeting and long-term financial planning process.
The pension plan that the City is a part of CalPERS assumes a 7% annual return.48 A recession would cause
CalPERS’s investments to perform below expectations. If the investments perform below expectations,
the City eventually has to make up the difference with increased contributions. This unplanned additional
expenditure would add more financial pressure in the aftermath of an economic downturn. It should be
noted that CalPERS is administered in such a way that member municipalities would not feel the
consequences of investment underperformance immediately – there is about a two-year lag. This means
that the City would have forewarning of an increase in its contribution after investments underperform.
However, since that increase would come on the heels of a recession it would certainly be an inopportune
time for the City to make additional pension payments. Therefore, there may be some role for reserves
to help cushion the blow.
To calculate the potential increase in contribution costs from a recession, we first obtained a distribution
of CalPERS expected returns. The average expected return is 7%. That means returns are expected to be
below 7% half of the time and above 7% the other half of the time.
Based on information from CalPERS, we learned that returns are expected to take the shape of a normal
distribution or bell curve. This means that most the time returns will stay close to 7% but a wider variation
is possible. Using estimates from CalPERS and records of what has happened during past recessions, we
found that returns during a recession might range from 6.2% to -11%. -11% would be an extreme result,
while something close to 6% would be much more likely during a recession.
Next, we estimated potential recession lengths. Using past recessions as reference cases, we found the
likelihood of a recession lasting one, two, or three years.49 Of course, a three-year recession is very
unlikely, and a two-year recession is unlikely.50 Most recessions would last about a year or so.
47 A recession is a significant decline in economic activity that lasts longer than a few months.
48 CalPERS, “CalPERS to Lower Discount Rate to Seven Percent Over the Next Three Years,” December 21, 2016,
https://www.calpers.ca.gov/page/newsroom/calpers-news/2016/calpers-lower-discount-rate.
49 We gathered recession lengths for every recession since 1950 and used that to simulate future recession lengths.
50 The Great Recession lasted 18 months. The Great Depression lasted just over 3.5 years.
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We then simulated thousands of possible recessions, where each recession lasted somewhere between
one and three years and the rate of return for each year of the recession was somewhere between 6.2%
and -11%. We then connected these variable rates of return to a pension contribution model developed
by Newport Beach City staff. This gave us a range of potential contribution increases due to a recession.
Exhibit 6.A.1 shows the results for a five-year period. Years 1, 2, and 3 are the potential recession years.
The additional pension cost to the City will always be zero in years 1 and 2 because the CalPERS system is
designed to defer the initial impact from investment underperformance. Year 3 is when the additional
costs are felt. In the vast majority of cases, a recession will be over by the third year. However, in extreme
cases a recession could go into a third year. Years 4 and 5 are recovery years, when the economy will very
likely have emerged from a recession. The rows in the exhibit show the percent confidence the City can
have that a given amount of money would be sufficient to cover the additional contribution costs in a
given year.
Exhibit 6.A.1 – Additional Pension Contributions in the Wake of a Recession
Confidence Year 1 Year 2 Year 3 Year 4 Year 5 Total*
50% $0 $0 $1,600,000 $2,700,000 $3,400,000 $7,800,000
60% $0 $0 $1,800,000 $3,100,000 $4,100,000 $9,100,000
70% $0 $0 $2,000,000 $3,800,000 $5,100,000 $11,000,000
80% $0 $0 $2,500,000 $4,800,000 $6,400,000 $13,500,000
90% $0 $0 $3,500,000 $6,300,000 $8,300,000 $17,700,000
*Total is a simulation for the entire three years at once, not counting each year individually. Hence, the
results are slightly different than if all three years were just summed arithmetically.
For the purposes of reserve planning, the numbers of greatest interest in Exhibit 6.A.1 are probably the
bolded and italicized ones in Year 3: the 70%, 80%, and 90% confidence levels. These represent particularly
harsh recessions. During a harsher recession, the City is presumably facing greater pressure on its
revenues and the recession would be longer, so the increased costs for pensions would be that much
more of a burden. By contrast, a recession at the 50% or 60% confidence level would likely be over after
one year, giving the City an entire year of recovery before having to shoulder increased pension costs.
For building a reserve for this risk, the City probably would not want to reserve the entire bolded/italicized
amounts shown in Exhibit 6.A.1. This is because the City will have forewarning of the impending costs and
could structure its budget accordingly. However, it might want some reserves in place so that budget cuts
do not have to be as dramatic as they would in the absence of reserves. For instance, a $2 million reserve
might assume that the City will cut $1.5 million in costs. $1.5 million is about equal to the amount needed
to cover the pension cost increase that would be associated with an average recession. $1.5 million in cuts
plus $2 million in reserves is $3.5 million or 90% confidence. A $1 million reserve might assume that the
City will cut deeper. For example, this means the City would be willing to cut $2.5 million in the case of a
very severe recession.
As we get into years 4 and 5 on Exhibit 6.A.1, the use of reserves becomes much more of a City policy
issue than an issue of technical risk analysis. The City will have at least one and, probably, two years of
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forewarning before experiencing these costs. The City could choose to handle these increased pension
costs through its regular planning and budgeting process, but could have some reserves set aside if the
City did not want to handle the costs only through increased revenue and/or spending cuts.
Finally, it should be noted that the historical records suggests that CalPERS returns rise above average
expectations immediately following a downturn (i.e., go above 7%). This would eventually reduce some
of the financial pressure on the City. It would not help for the period of time we are interested in for a
reserve strategy, but it does at least suggest that the City’s long-term prospects in the aftermath of a
recession may be less dire than suggested by Exhibit 6.A.1.
Subsection B - Debt (Not Including Pensions)
Any form of leverage could reduce the City’s financial flexibility, thus increasing the need for reserves to
provide some offsetting flexibility. For example, if the City had a great deal of outstanding debt, it might
find it more difficult to borrow funds in the case of an emergency.
The City’s existing debt policy provides a set of guidelines to encourage positive use of debt for
investments like capital infrastructure. The policy requires that debt only be used if it meets the City’s
payment distribution goals, is the most cost-effective funding means available, and is fiscally prudent.
These guidelines provide stability to the City’s debt portfolio. According to its comprehensive annual
financial report, the City’s debt policy is recognized by the California Debt and Investment Advisory
Commission as one of only 14 equivalent city/county policies in California with 20 or more debt
management best practice elements.
At the end of FY 2016, the City had total long-term debt outstanding of $116.5 million. The City has an
Issue Credit Rating of AAA as assigned by Standard & Poor’s Rating Services. A rating of AAA by Standard
& Poor’s Rating Services is roughly equivalent to an Aaa rating by Moody’s Investors Services.
The following table, Exhibit 6.B.1, uses figures from the City’s FY 2016 CAFR to compare Newport Beach’s
debt to similar sized cities. The table shows median indebtedness, by credit rating as reported in Moody’s
Investors Services. The City’s level of net direct debt, which includes a non-self-supporting portion of
general obligation bonds, sales and special tax bonds, general fund lease obligations, bond anticipation
notes, and capital leases, compared to its full value, or estimated full market value of taxable property
within its boundaries, is only 0.25 percent. This is a good deal lower than the medians across the six
ratings. While the actual net direct debt for the City is higher than the medians in the same population
bracket, the low percentage indicates the City is in a healthy position with respect to the kind of debt
typically used acquiring capital assets.
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Exhibit 6.B.1 - Comparison of Newport Beach’s Financial Indicators to Cities with Between 50,000 and 100,000
in Population by Credit Rating
Newport Beach Aaa Aa A Baa Ba
Net Direct Debt as % of Full Value 0.25% 0.6% 1.1% 2.0% 3.9% N/A
Net Direct Debt ($000s) $116,544 $59,300 $64,143 $78,275 $170,848 N/A
Source: “2015 US Local Government Medians – Tax Base Growth Reinforces Sector Stability as Pension Troubles Remain,” Moody’s Investors
Service (March 30, 2017).
Exhibit 6.B.2 includes a group of California cities that are comparable to Newport Beach based on a
combination of factors, including geography, population, general fund revenue portfolio, and size. The
exhibit provides summary statistics from each of the cities’ FY 2016 CAFR and includes four commonly
used measures of indebtedness. The measures are categorized as “Measures of Direct Debt” and
“Measures of Overall Debt.”
Direct debt considers only bonded debt issued by the City of Newport Beach. Within this category, the
first measure is debt service (principal and interest payments) as a percent of City expenditures. This figure
gauges the pressure placed on the budget by debt payments. The second measure shows direct debt as a
percent of the City’s full assessed value. This shows debt burden relative to the City’s tax base.
Overall debt captures the full burden placed on the public by debt issued by all local governments that
overlap Newport Beach. Within this category, the first measure shows the burden placed on citizens by
municipal indebtedness inclusive of direct and overlapping debt. The second measure compares direct
debt plus the debt of overlapping jurisdictions as a percent of the full assessed value of properties in the
jurisdiction.
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Exhibit 6.B.2 - Comparison of Newport Beach's Indebtedness with Other Cities
Newport Beach Laguna
Beach
Huntington
Beach
Santa
Monica
Costa
Mesa
Mission
Viejo
Population 84,915 23,505 197,574 93,834 114,044 96,718
Measures of Direct Debt
Debt Service as a % of
Expenditures 5.42% 0.00% 3.22% 2.84% 3.10% 3.86%
Net Direct Debt as % of
Full Value 0.25% 0.00% 0.14% 0.25% 0.15% 0.09%
Measures of Overall Debt
Overall Debt per Capita $8,603 $1,779 $2,823 $7,900 $1,615 $1,071
Overall Debt Burden
(Overall Net Debt as %
Full Value)
1.54% 0.33% 1.58% 2.38% 1.11% 0.68%
Source: FY 2016 CAFR for each represented city.
Exhibit 6.B.2 shows that Newport Beach has the highest overall debt per capita when compared to its peer
cities, but falls in the middle of its peers when looking at overall debt burden as a percent of full assessed
value.
For direct debt, Newport Beach is relatively similar to its peers. While the City has the highest percentage
of debt service as a percent of all expenditures at 5.42 percent, it is mostly comparable to the other cities
when calculating direct debt as a percentage of full value. While the City does appear to have slightly
higher debt measures than its counterparts, it must be considered that several of the comparables have
extremely low amounts of debt to begin with, specifically Laguna Beach with no direct debt reported in
the FY 16 CAFR.
To conclude our discussion on debt, Newport Beach’s has a relatively low overall debt burden, which is
illustrated by its high bond rating and low overall burden relative to other cities of comparable size across
the United States. Newport Beach’s debt levels are not much different than nearby comparable cities, but
these cities also have little debt. Newport Beach’s favorable debt position provides it with financial
flexibility to complement a reserve strategy.
Subsection C - Other Post-Employment Benefits (OPEB) Liabilities
The City has manageable OPEB liabilities. In FY 2016, its annual OPEB cost amounted to $2.8 million.
Newport Beach has also taken measures to mitigate funding risk by setting up a CalPERS OPEB trust to
prefund OPEB obligations. Because of the proactive measures the City has taken to address its OPEB
obligations, no specific general fund reserve is recommended. However, the City should continue its
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practice to make its full actuarially required contribution and to administer the OPEB trust that is has
created.
Subsection D – Expenditure Spikes
The City does not have large impending lawsuits against it. There is an external reserve to cover any
lawsuits the City may face. If that fund were to be depleted, there may be cause for concern, but
historically this has not been an issue. Of course, if the City encounters a situation in the future where a
large impending lawsuit materializes, it will want to adjust its risk management strategy. However, for
now, there does not appear to be compelling evidence that additional reserves are needed.
Subsection E – Liquidity
According to historical revenue data, the City receives about 45 percent of its annual revenue between
July 1 and December 1. Most of that 45 percent comes during the month of December from property
taxes; about 21% of the City’s entire yearly revenues are collected in December. This means that the City’s
revenue receipts are slightly weighted towards the latter part of the fiscal year. However, this appears to
be a relatively minor risk that can be addressed in two ways.
First, the reserves recommended in this report can serve as “de facto working capital”. The relatively
minor liquidity concerns the City might experience could be absorbed within its regular reserves.
Second, the City’s investment policies and practices can provide for sufficient liquidity to ensure that the
City’s idle funds are available when needed during the early part of the year. For example, the City staff
perform cash flow analysis monthly and have a plan in place to liquidate investment maturities as cash is
needed. The City’s investment strategy also anticipates these peaks and valleys in the City revenue
inflows.
Subsection F – Growth
Population growth has remained relatively stable and plateaued. Hence, a potential resource strain due
to population growth is not a risk.
Subsection G - Claims on General Fund Balance
The reserves that the City sets aside for risk mitigation are a subset of the City’s fund balances. Fund
balance is the difference between the general fund’s assets and liabilities. Sometimes, there are claims
on fund balances that make those balance unavailable for risk mitigation.
The City’s FY 16 CAFR details claims on the City’s existing fund balance. As of FY 2016, the General Fund
balance was $81.8 million.
$15.2 million of this is classified as nonspendable. These nonspendable funds are long-term loan
receivables, prepaid items, and inventories. The restricted general fund balance amounts to $3.1 million,
intended for use in a variety of general fund activities including affordable housing and oceanfront
encroachment. This total of about $18.1 million constitutes a solid claim that makes this portion of fund
balance unavailable for risk mitigation.
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The City has $2.7 million classified as committed by City Council. Much of this is an encumbrance reserve.
While the City could, hypothetically, redirect these funds to other purposes, it is not the City’s intent to
redirect these funds. Hence, we might also consider these commitments to be a claim on fund balance.
Assigned fund balance is about $4.2 million. Most of this is a wastewater subsidy. While intended to be
more flexible than a “commitment”, the City still has expressed an intention to use this money for
something other than risk management.
That leaves $56.6 million as unassigned fund balance. Unassigned fund balance doesn’t have claims on it
and could be used for risk mitigation.
In conclusion, the City has a substantial amount of unassigned fund balance. The City also has some
assigned and committed restrictions are self-imposed, so, if needed, the City could draw on these in an
emergency.
Secondary Risk Checkpoints
Of the secondary risks we examined, only the possibility of increased pension payments in the
aftermath of a recession appears to be significant risk.
The way in which CALPERS is administered has the effect of deferring the effects of investment
underperformance on the City for a two-year period. This means the City would not face immediate
increased pension costs during an economic downturn. There is then a five year smoothing beyond
that.
A reserve of between $2.0 million and $3.5 million would give the City 70% to 90% confidence of
being able to cover the increased pension costs in the third year after an economic downturn (i.e.,
after the aforementioned two-year period passes).
The City could also experience increased annual pension costs four and five years after a recession.
However, because this is a number of years after a recession occurs, planning for these costs might
be better handled through the City’s long-term planning and budgeting process, rather than
reserves.
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Section 7 - Putting it All Together
In Sections 4, 5, and 6, we examined individual risks such as earthquakes, floods, fires, and revenue losses
due to economic downturns. We examined each of these risks individually in order to best understand
the nature of each risk, and we found a range of reserves that represents an “efficient” use of reserves
for mitigating each individual risk. However, to arrive at a final reserve strategy for the City we need to
consider these risks as a group. Considering the risks as a group has important advantages.
The first advantage is that considering risks as a group recognizes the diversity in the risks that the City
faces. This diversity actually is an advantage for City finances! Diversity in risks means we should not simply
add together each of the reserve ranges for each individual risk. This may overstate the amount of
reserves that the City really needs. This is because it is very unlikely that the City will experience a severe
earthquake, recession, fire, and flood all within a short time period. Exhibit 7.1 below illustrates using fires
and floods. Let’s imagine that the City wanted to be 95% confident that it could cover the damages from
a flood and a fire. The table shows the amounts needs for each individual risk and then adds them together
in a simple summation, arriving at $1.6 million. The “combined distribution” column creates an entirely
new distribution from the data we have for fires and floods together. The 95% confidence level for this
new distribution is only $1.47 million or about 8 percent less than the simple summation. This is
recognizing that it is highly unlikely that the City will experience a severe fire and a severe flood at once.
Rather, it is more likely that at least one of the events would be much milder. When we consider all of the
City’s risks in this manner, the reserves required to achieve a given level of confidence will be much less
than when each risk is considered in isolation.
Exhibit 7.1 – Reserve Needed to be 95% Confident for Fire and Flood Risk
Fire Flood Simple
Summation
Combined
Distribution
Difference
95%
Confident
$159,000 $1,431,000 $1,590,000 $1,473,589 8%
The second advantage of considering all of the risks together is that not all of the risks have an equal
chance of occurring over a given time period. For example, Newport Beach has experienced three floods
in its recent history, but no earthquakes. This suggests that floods are more likely to occur than
earthquakes. The City’s reserve strategy should reflect this fact. In the bullet points below, we show the
relative chance of each of the major risks occurring over a ten-year period. We can use these probabilities
to build a probabilistic model of risks over a long-term time horizon. You will note that some of the
extreme events are expressed as a fraction. Of course, the City can’t experience a portion of an event, but
the fraction does impact our simulation of risk. For instance, the City can expect to experience 1/3 of a
wildfire in a ten-year period. If we created three different ten-year simulations, we might expect one of
them to include a wildfire. We can create hundreds or even thousands of ten-year simulations, so there
will be many that include a wildfire.
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• Revenue loss due to a recession. Historical data suggests that it is highly likely (over 90% chance)
that there will be at least one recessionary year in a ten-year period.51 The historical data also
tells us there is a considerable chance of having more than one recessionary year in a ten-year
period.
• Earthquake. Data obtained through the US Geological Survey (USGS) suggests that the Los
Angeles area has about a 32% chance of experiencing an earthquake of a magnitude of at least
6.0 over a ten-year period.52 Of course, not every part of the Los Angeles region will be relevant
to the risks faced by Newport Beach. However, given that some faults further from Newport Beach
still pose a threat (i.e., San Andreas) much of the LA region is still relevant. Hence, we judged it
prudent to use the probability for the entire Los Angeles region.53
• Flood. The City has experienced three FEMA-declared flood disasters between 2004 and 2017, a
13-year period. Hence, over ten-year period we might expect “2.3” floods.
• Fire. The City has experienced one wildfire every 30 years. This means the City can expect “1/3”
of a wildfire every ten years.
The final advantage of considering all of the risks together is that we can consider “risk
interdependencies”. This simply means that the occurrence of one risk could impact the probability
and/or magnitude of a related risk. Perhaps the strongest and most obvious dependency is between
revenue losses from a recession and spikes in pension costs due to CalPERS investment under-
performance – both are caused by an economic downturn and both are worse for the City the worse the
recession gets. We examined the potential for other interdependencies as well, but concluded that they
weren’t as important. For example, could an earthquake lead to a wildfire? The City’s Fire Chief advised
us that the areas where a wildfire could start are not exposed to infrastructure that could be damaged
and start a fire as a result (e.g., electrical lines). Could an earthquake lead to tsunami? The USGS analyzed
the potential impact of a 7.8 earthquake on the southernmost 200 miles of the San Andreas fault, the area
thought to be at greatest risk to produce a large quake. The USGS found that because of the large distance
from the earthquake to the coast, tsunamis are not a significant risk.54
To realize the advantages described above, we built a model that considers the City’s risks over a ten-year
time horizon. As with our other models, the model runs hundreds or even thousands of simulations of
possible futures for Newport Beach. Here are the key assumptions behind the model:
• Probability of an undesirable event. The probability of any undesirable event occurring (e.g., fire,
flood, earthquake, etc.) is consistent with the assumptions described above.
• Magnitude of an undesirable event. Should a simulation show that an undesirable event occurs
in a given year, the magnitude is generated randomly in a manner identical to the individual risk
models we showed earlier in this report.
51 We took economic data since 1950 and used that to calculate the odds of a recession occurring in a ten year
period, including how many of those years would be recession years.
52 Edward H. Field, et al. “Long-Term Time-Dependent Probabilities for the Third Uniform California Earthquake
Rupture Forecast”. Bulletin of the Seismological Society of America, Vol. 105, No. 2A, pp. 511–543, April 2015.
53 Further, data to calculate a probability specifically for Newport Beach or Orange County was not available. This
means that the probability of an earthquake occurring is probably somewhat overstated. We tried using a somewhat
lower probability to see what the difference was and observed that implications for reserves was not large.
54 Lucile Jones, et al. “The ShakeOut Scenario”. US Geological Survey. 2008.
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• Interdependencies. Should our simulation show that a recession occurs in a given year, then both
a revenue loss and a pension loss of similar magnitude will be triggered.
• FEMA reimbursement. The City could recoup some of its losses from extreme events due to
reimbursements from FEMA. The model assumes the reimbursements are received two years
after the event occurs.55 The model also assumes that a disaster must cost the City at least
$100,000 to receive any reimbursement (anything smaller would not be declared a FEMA-eligible
disaster). We also assume the City will be reimbursed at the customary rate of 75% of incurred
costs.
• The City cuts spending to help offset the impact of an extreme event. The City will not use
reserves to absorb the full impact of an extreme event, like a recession or natural disaster (either
increased costs or revenue losses). At least some of the loss could be absorbed by cutting back on
the City’s regular spending. A discussion with City staff and the Finance Committee suggests that
the City could be able to cut about 2% of its budget in order to absorb unexpected financial
impacts. The cut could be accomplished through a number of different strategies, such has
deferring maintenance of existing city assets, deferring purchases of certain new assets, and
cutting back on some operating transfers out of the general fund. Smaller cuts in the City’s
operating expenditures also help absorb the loss.
• City cuts spending in other areas to in response to spike in pension costs. Similar to the revenue
loss, it is assumed that the City’s reserve would not absorb the entire amount of a pension cost
increase. Again, it is assumed spending cuts will absorb 70% of the first year of pension cost
increases in the aftermath of recession. For subsequent years, it is assumed that 100% of
increased costs would be accommodated within the City’s regular budget.
• A reserve of $10 million is the City’s “red line”. All of the analysis assumes the City will want to
stay above at least $10 million dollars in its reserve. This recognizes the fact that the risk analysis
cannot account for every possible problem that could ever befall the City. $10 million is the City’s
stated preference for a cushion against these unknowable risks.
We combined all of the information described above to create at ten-year probabilistic model. The model
produces a curve, much like what we presented for the City’s individual risk factors. The curve is
presented in Exhibit 7.2. It shows the level of confidence the City can have that a given level of general
fund reserves will prove sufficient over a ten-year period to cover the extraordinary costs incurred by the
general fund as a result of the risks covered in this report. “Sufficient” is defined as the reserves not
dropping below $10 million. For example, the City can be 80% confident that a reserve of $19.4 million
would cover the City general funds extraordinary expenditures over a ten-year period, without needing
to go below $10 million in the City’s remaining reserve.
55 Our research shows that FEMA reimbursements are completed 18 months after the disaster occurs, on average.
So, this is a conservative assumption.
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Exhibit 7.2 – Confidence that a Given Level of General Fund Reserves will be Sufficient over 10 Years
Reserves
(Millions
of Dollars)
Percent Confidence
As with the other curves we have shown in this report, there is a point at which the curve begins to rise
sharply. This is the point at which the City starts to receive less value from reserves. In Exhibit 7.2, this is
between the 70% confidence level ($14.8 million) and 90% confidence level ($25.5 million). This
represents the range at which reserves produce the best value for the City (note the City would need to
add its $10 million dollar “red line” to these amounts to get the total desired reserve). However, there are
a number of other factors that are worth considering as part of settling on a reserve level:
Other risk management mechanisms can complement reserves. Understandably, City officials might not
be satisfied with an 80% or 90% chance of being able to cover damages from the risks we described in this
report. Other financial risk management tools like debt or insurance could be used to provide additional
confidence beyond that provided by reserves.
Our analysis is not inclusive of every risk the City could possibly face. We used the City’s disaster
management plan to identify the risks that posed the most clear and present danger to the City. However,
it is possible that the City could experience a shock that no one was expecting. Hence, there is a case for
reserving more than our analysis suggest is efficient. This could provide additional protection against risks
that no one can foresee. That is why the City set a $10 million minimum reserve “red line” that our reserve
analysis took into account.
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Our analysis is based on historical records. Global climate change could increase the City’s vulnerability
to naturally occurring extreme events.56 This means that historical data could underestimate the
likelihood and/or severity of extreme events in the future. Unfortunately, no one can say precisely what
the impact of climate change will be. Hence, GFOA can’t speculate if an upward adjustment to the reserves
is necessary and, if so, by how much. However, this does mean that there could be a case for reserving a
higher amount than the efficient range described above (or pursuing other risk management strategies).
Also, GFOA’s Microsoft Excel 57 risk model provides the City with the ability to adjust the likelihood and/or
magnitude of future extreme events, if it would like to test different scenarios.
The reserves held by comparable cities. The reserves held by comparable cities can provide context to
the City of Newport Beach’s officials for selecting their own reserve levels. Appendix 1 contains a detailed
comparison of Newport Beach’s fund balance with those of Laguna Beach, Huntington Beach, Santa
Monica, Costa Mesa, and Mission Viejo. The comparison shows that Newport Beach has more reserves
set aside specifically for responding to emergencies than the other cities. Newport Beach has an amount
equal to about 23% of annual revenue. Of the three other cities that have reserves set aside specifically
for emergencies, those cities have an average reserve of about 10% of annual revenues. By way of
comparison, the 90% confidence reserve we showed in Exhibit 7.2 is about $13 million, which equates to
around 7% of annual revenue. In the two paragraphs above, we suggested a few rationales for why the
City might wish to have reserves somewhat higher than our suggested “efficient” range. If GFOA’s range
were augmented a bit, the resulting reserve would be pretty similar to the amount maintained by the
other cities.
The City’s desired level of reserves should be memorialized in a formal policy and expressed as a percent
of revenue or expenditures. The City already has such a policy, so the policy can be updated based on
how the City wishes to use GFOA’s analysis to adjust its desired level of reserves. The dollar figures
contained in this report can be converted into a percent of the City’s annual revenues or expenditures.
This way, the dollar amount will automatically adjust with changes in the City’s budget.
The City’s desired level of reserves should be a range, rather than a single number. GFOA’s research into
how local governments can best maintain financial sustainability has found that decision-making
“boundaries” are essential. For example, if the City were to adopt a policy to maintain reserves between
X% and Y% of revenues, then that would constitute a clear boundary that defines when reserves are too
high or too low. Compare this to if the City just adopted a policy that reserves should be at X% of revenues.
It is then impossible to say how far reserves can go above or below this number and still be an acceptable
amount. A range also can accommodate the risk appetites of more City officials. Thus, a range could be
more reflective of the preferences of a greater number of people and, thereby, get more support.
56 According to “The Impact of Climate Change on Natural Disaster”, an article from NASA’s “Earth Observatory”:
“outcomes of an increase in global temperatures include increased risk of drought and increased intensity of storms,
including tropical cyclones with higher wind speeds, a wetter Asian monsoon, and, possibly, more intense mid-
latitude storms.” https://earthobservatory.nasa.gov/Features/RisingCost/rising_cost5.php?src=share
57 GFOA has provided the model to the City so it can run its own scenarios
A Risk-Based Analysis of General Fund Reserve Requirements for the City of Newport Beach
Produced by the Government Finance Officers Association Page 55 of 57
Section 8 - Next Steps
Based on the information presented in this report, we suggest that Newport Beach take the following
steps:
#1 - Pick a desired range of reserves.
This can be based on what our analysis suggests is efficient. It will also depend on City officials’ appetite
for risk. Section 7 provided a number of suggested factors that might help City officials decide on their
preferred level of reserves.
#2 - Consider how debt and insurance can complement the reserve strategy.
Debt and/or insurance can provide protection to the City past the point where reserves are efficient.
In the case of debt, the City might be able use a line of credit with a local lending institution (the City
already has a $1 million line of credit with a local bank), certificates of participation, or revenue
anticipation notes. The City might also think about interfund borrowing opportunities. Equipment/facility
replacement funds, worker’s compensation fund, facility maintenance funds might all be able to make
short-term loans to the general fund in the case of an emergency. The City could develop policies to
provide the flexibility to use these borrowing tools while also providing the necessary guidelines and
limitations to ensure that borrowing occurs in a fiscally prudent manner.
The City could also investigate newer types of insurance instruments, like parametric policies. Parametric
policies were described earlier in this report.
#3 - Memorialize the City’s desired range of a reserve in a formal policy.
We strongly recommend expressing this as a range, rather than a single number. A range provides a
“boundary” within which decisions must be made.
A Risk-Based Analysis of General Fund Reserve Requirements for the City of Newport Beach
Produced by the Government Finance Officers Association Page 56 of 57
Section 9 - Appendix 1: Reserves in Comparable Cities
To help the City consider the exact amount of reserves to maintain, Exhibit 9.1 provides a table of General
Fund balances as a percent of General Fund revenues for California cities that are comparable to the City
of Newport Beach. Several notes should be made about Exhibit 9.1 in order for the reader to fully
understand its meaning. First, “fund balance” is an accounting term describing the difference between
assets and liabilities in the General Fund. “Reserves” (which are the main topic of GFOA’s analysis for
Newport Beach) are the portion of fund balance set aside, by City Council policy, as a hedge against risk.
Hence, not all “fund balance” is necessarily available as a reserve. The three right-most columns of Exhibit
8.1 shows how much each city holds in fund balance as a percent of general revenue. Each of the three
columns in this exhibit examines fund balances from a different perspective on the relationship between
fund balance and risk mitigation.
The column #1 shows “unrestricted” fund balance as a percentage of General Fund operating revenue.
This is an accounting term describing fund balances that do not have constraints placed on their use by
an outside entity (e.g., a bond covenant might restrict the use of some portion of fund balance to debt
service) and are spendable (e.g., do not represent inventory or other non-liquid assets). This the broadest
definition of fund balance we show in Exhibit 9.1. An “unrestricted” fund balance may still have constraints
placed upon its use, but these constraints would be created by the city government itself. One common
constraint is to dedicate some portion of fund balance to hedging against the types of risks described in
this report. However, other constraints have nothing to do with risk mitigation - to illustrate: a common
self-imposed constraint is setting aside fund balance to pay for a special capital project. Newport Beach
has imposed several such constraints; for example, the city has about $790,000 in funding committed for
NPTV programming. While such a constraint could be removed and, thus, the entirety of monies in the
“unrestricted” category made available for risk mitigation, it is not the intent of the city to do so.
Column #2 shows the amount of fund balance available for risk mitigation after fund balances having self-
imposed restrictions (not germane to risk mitigation) are removed from consideration. Because have
removed funds that are the subject of self-imposed restrictions, this category is narrower than the first
category. This leaves self-imposed restrictions that are specifically germane to risk mitigation as well as
unrestricted fund balance (i.e., fund balance for which no restrictions at all have been identified).
Unrestricted fund balance could easily be used for responding to emergency events, if needed.
Column #3 includes only those fund balances that have been specifically identified by the city government
as intended for creating a risk mitigating reserve. It should be noted that since the analysis in Exhibit 9.1
is based only upon the information included in each city’s FY 2016 CAFR, it is possible the amount
dedicated to risk mitigation could be somewhat higher for some of the cities as a legislative policy
document might call for maintaining a given amount in fund balance as a reserve without creating an
accounting restriction that would show up in the financial report. For example, Newport Beach’s CAFR
dos not call out risk mitigating reserve in the financial statements, but one is described in the management
discussion and analysis.
It is also important to note that some cities, like Laguna Beach, account for emergency reserves in a fund
outside of the general fund. These other funds appear to be substantively similar in purpose to the
A Risk-Based Analysis of General Fund Reserve Requirements for the City of Newport Beach
Produced by the Government Finance Officers Association Page 57 of 57
general fund reserve Newport Beach is considering, but just are located in a separate fund. This does not
include reserves that are found in utility funds or other funds with operational responsibilities apart
from the general fund. We have included these amounts in column three to provide for greater
comparability between the cities.
Exhibit 9.1- Fund Balances as Percent of General Fund Revenue
City Population (#1)
Unrestricted
(#2)
Available for
Risk Mitigation
(#3)
Dedicated to Risk
Mitigation
Newport Beach 84,915 32% 28% 23%
Laguna Beach 23,505 83% 33% 8%
Huntington Beach 197,574 27% 11% 11%
Santa Monica 93,834 96% 19% 0%
Costa Mesa 114,044 51% 38% 12%
Mission Viejo 96,718 55% 24% 0%
Average 101,765 57% 25% 9%
Median 95,276 53% 26% 10%
Sources: FY 2016 CAFR for each city.
Given that column #3 is the most relevant to our analysis, it bears a closer look. Starting, with the City of
Newport Beach’s, we see a reserve equal to 23% of revenues. This is the City’s Contingency Reserve. The
reserve can be found as part of “Unassigned” fund balance in the City’s CAFR and amounts to $45.8
million. The City’s policy states that this amount exists to provide assistance in emergency situations.
Many of Newport Beach’s peer cities have similar emergency funds set up. Laguna Beach’s Disaster
Contingency Fund exists outside the General Fund, and has a total fund balance of $6.2 million to be used
exclusively for repairing public facilities and protecting lives/property. During FY 16, Huntington Beach’s
City Council established the Economic Uncertainties Reserve in the General Fund, which creates a reserve
to be used for catastrophic events and natural disasters. The Council’s goal was to commit the value of
two months of the General Fund expenditure adopted budget amount to this fund. The City of Santa
Monica’s Disaster Relief Fund typically assists with covering expenses of a natural disaster. As of FY 16,
the City’s fund had a net zero balance; the City received and promptly used a Federal and State Earthquake
grant in FY 16 of $2.7 million. Additionally, $15,123 was transferred from the Disaster Relief Fund to the
General Fund to “close out” the fund. It is unclear whether or not the fund will remain in use. While the
City had a fund of that amount at some point during the year, the year-end balance is a net zero. The City
of Costa Mesa has significant committed funds for declared disasters in the general fund. The fund
currently has $14.1 million dollars, and per City ordinance, any fund balance utilized must be replenished.
The City of Mission Viejo had no existing emergency or disaster fund.
Exhibit 9.1 shows that Newport Beach has the most available for contingency.
Government Finance Officers Association
May 2013
A Risk-Based Analysis
ofGeneral Fund Reserve
Requirements
A Case Study of the City of Colorado Springs
Copyright 2013 by theGovernment Finance Officers Association203 N. LaSalle Street, Suite 2700Chicago, Illinois 60601www.gfoa.org
By Shayne C. Kavanagh, Senior Manager of Research, GFOA
Reviewers: Marc D. Joffe, Principal Consultant, Public Sector Credit Solutions, and Bill Statler, Consultant andTrainer; retired Director of Finance & Information Technology, City of San Luis Obispo, California.
The GFOA would like to thank the City of Colorado Springs for allowing us to share this information, and PublicSector Digest for their assistance.
The Research and Consulting Center is the management analysis and consulting arm of the GovernmentFinance Officers Association and is nationally recognized for its comprehensive analytical and advisory serv-ices, and specialized research on state and local government finance. Since beginning operations in 1977, theGFOA Research and Consulting Center has provided advisory services to hundreds of local, county, and stategovernments; public utilities; elementary and secondary education systems; and transit authorities.
The GFOA’s Research and Consulting Center encourages enquires about this study or about repeating theanalysis for other governments — please contact Shayne Kavanagh at 312-977-9700 or skavanagh@gfoa.org.
Executive Summary............................................................................................................4
1. Introduction ....................................................................................................................7
2. Primary Risk Factor Analysis ........................................................................................9
Revenue Source Stability ......................................................................................9
Infrastructure........................................................................................................14
Vulnerability to Extreme Events and Public Safety Concerns............................15
3. Secondary Risk Factor Analysis..................................................................................17
Leverage................................................................................................................17
Expenditure Volatility............................................................................................19
Growth of the Community....................................................................................20
Liquidity ................................................................................................................20
4. Recommendations ......................................................................................................22
Recommended Reserve Target for Colorado Springs........................................22
Other Ideas to Support the General Fund Reserve Strategy ............................26
Appendix 1. Sales Tax Revenues in Boulder, Colorado ................................................31
Endnotes ..........................................................................................................................32
The Case of the City of Colorado Springs
4
Executive Summary
Reserves are the cornerstone of financial flexibility. Reserves provide a government with options for
responding to unexpected issues and a buffer against shocks and other forms of risk. Managing re-
serves, however, can be a challenge. The main question is how much money to maintain in reserve –
how much is enough, and when does it become too much? This can be a sensitive question, since
money held in reserve is money taken from constituents, and it can be argued that excessive reserves
should be returned to citizens in the form of lower taxes.
The City of Colorado Springs, Colorado, has been considering this question, especially in light of its
volatile revenue portfolio and the fact that it cannot easily increase taxes to compensate for other
changes in its financial condition; for example, the Taxpayer Bill of Rights – a statewide provision re-
stricting all governments in the state from raising tax rates without voter approval – limits the City’s
ability to increase taxes. The City engaged the Government Finance Officers Association to help pro-
duce an answer. The GFOA is a non-profit association of approximately 17,500 state and local govern-
ment finance professionals and elected officials from across North America, and a key part of its
mission is to promote best practices and good public finance, including reserve policies.
The GFOA worked with Colorado Springs to analyze the risks (based on the model originally de-
scribed in the GFOA publication, Financial Policies) that influence the level of reserves the City needs
as a hedge against uncertainty and loss. Three primary risks were identified: volatility of sales tax rev-
enue; the potential for the City’s storm sewer and bridge infrastructure to fail; and the City’s vulnera-
bility to extreme events such as wildfires, floods, and, to a lesser extent, snowstorms. Secondary risk
factors were also examined, including cash flow and the potential for unexpected spikes in expendi-
tures. In addition, a benchmarking survey of the reserves held by comparable cities provided context.
CALCULATING THE RESERVE
The GFOA reviewed three primary risk factors in order to assess the potential magnitude of the
City's exposure. The "Triple-A” approach to accounting for uncertainties was an important part of
GFOA's analysis.
Accounting for Uncertainty – The “Triple-A” Approach
Sizing a reserve requires estimating highly uncertain events, like natural disasters and economic downturns. To
develop an adequate response, the GFOA used the “Triple-A” approach:1
•Accept. First, we must accept that we are subject to uncertainty, including events that we haven’t even
imagined.
•Assess. Next, we must assess the potential impact of the uncertainty. Historical reference cases are a
useful baseline.
•Augment. The range of uncertainty we really face will almost always be greater than we assess it to be, so
we should augment that range. Historical reference cases provide a baseline, but that baseline may not be
adequate to account for all future possibilities.
5
Revenue Volatility. The City’s primary concern was the volatility of sales tax income, and its most im-
portant vulnerability in this area would be an economic downturn. The GFOA reviewed sales tax
volatility back to 1996 in order to observe monthly variations and longer-term trends. Past experi-
ences suggested that Colorado Springs should prepare for a 20 percent decline in sales tax revenues
over 25 months as a plausible worst-case scenario; this would equal about $23 million in reserves.
However, since the City would presumably reduce its spending in the event of such a severe down-
turn, the reserve fund wouldn’t have to cover the entire decline in revenue. The City budget office es-
timated that the budget could be reduced by almost $10 million without creating a major disruption
to services (although there would of course be some degree of negative impact on service quality).
Thus, Colorado Springs should maintain a reserve of at least $13 million to cover the remaining por-
tion of the worst-case revenue gap and to help the City make a “soft landing” under those circum-
stances. An additional $7.5 million is required to cover the other revenues that make up the general
fund; these were found to be considerably less volatile than the sales tax.
Infrastructure Risks. A government might need general fund reserves to repair or replace an asset that
fails unexpectedly. In Colorado Springs, the two major asset classes deemed to have the greatest as-
sociated risk were bridges and storm sewers. Thirteen bridge structures had a high risk rating, with
an estimated replacement value of almost $23 million – an average of roughly $1.75 million per
bridge. A reserve that covers one or two bridges should be adequate, but covering three might be
more prudent, for a $5.25 million reserve. No installation dates or condition assessments were avail-
able for the 406 miles of storm lines the City manages, but the estimated replacement cost for all
storm sewers was a little more than $588 million.2 Since this lack of information made it impossible
to assess the risk of failure, the best that could be done was to make an assumption. The GFOA did
know that about 10 percent of the total dollar value of the City’s bridge inventory is in the higher-risk
category, so it started with that number for storm sewers, which translates to $58 million. The rec-
ommended reserve amount is about 20 percent of the high-risk bridges, which equates to $11.6 mil-
lion for storm sewers.
Extreme Events. Finally, the City is subject to extreme events that pose significant threat to life and
property, particularly wildfires and floods. Historically, however, the financial impact of these events
has been manageable. For example, the 2012 wildfire was the worst in Colorado history, but the total
cost to the City was only $3.75 million – out of an annual budget of approximately $220 million. Of
course, the scale of future events is uncertain, as is the timing of FEMA reimbursement and the por-
tion of event response costs that would likely already be covered by existing budgeted resources. Tak-
ing this into account, a reserve of $5 million to $7.5 million for extreme events appears reasonable.
Adding It Up. The analysis above, along with the analysis of the secondary risk factors (particularly
uncertainty regarding future payments for pension liabilities and expenditures for unfavorable law-
suit judgments) led to the following reserve components. The GFOA further recommended that the
reserve amounts be categorized by component, making the purpose of the reserve more transparent.
For example, having a reserve for emergencies and a reserve for economic uncertainty would make
their purpose more clear than one all-encompassing reserve.4
6
Budgetary Uncertainty Reserve
$13 million for sales tax economic uncertainty +
$7.5 million for economic uncertainty in other revenues +
$6.25 million for pension payment uncertainty =
$27 million, or approximately 12.5 percent of general fund revenues3 as budgetary
uncertainty reserve
Emergency Reserve
$5.25 million for critical bridge failure +
$11.6 million for critical storm sewer replacement +
$5 million to $7.5 million for extreme events +
$2 million to $4 million for expenditure spikes from lawsuits =
$27 million, or approximately 12.5 percent of general fund revenues as an emergency
reserve
Combining the components gives us a target of approximately 25 percent of general fund rev-
enues, which is in line with the range of reserves actually maintained by other cities that are compa-
rable to Colorado Springs. It is also greater than the 16 percent the GFOA considers a minimum
baseline level.5
7
1. Introduction
Reserves are the cornerstone of financial flexibility. Reserves provide a government with options to
respond to unexpected issues and afford a buffer against shocks and other forms of risk. Managing
reserves, though, can be a challenge. Foremost is the question of how much money to maintain in
reserve. How much is enough and when does a reserve become too much? This can be a sensitive
question because money held in reserve is money taken from constituents and the argument could
be made that excessive reserves should be returned to citizens in the form of lower taxes.
The City of Colorado Springs (the “City”) has been considering this question recently, especially in
light of the volatility of its revenue portfolio and the fact that the City cannot easily increase its taxes
to compensate for other changes in its financial condition.6 The City engaged the Government Fi-
nance Officers Association (GFOA) to help produce an answer. The GFOA is a nonprofit association
of over 17,000 state and local government finance professionals and elected officials from across
North America. A key part of GFOA’s mission is to promote best practices in good public finance, in-
cluding reserve policies.
The GFOA’s approach to reserves does not suppose “one-size-fits-all.” GFOA’s Best Practice on gen-
eral fund reserves 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 (i.e., reserves equal
to about 16 percent of revenues).7 However, this 16 percent is only intended as a baseline, and it
needs to be adjusted according to local conditions. To make the adjustment, the GFOA worked with
the City to conduct an analysis of the risks that influence the need for reserves as a hedge against un-
certainty and loss.
A risk is defined as the probability and magnitude of a loss, disaster, or other undesirable event.8 The
GFOA’s framework of risk assessment is based on the risk management cycle: identify risks; assess
risks; identify risk mitigation approaches; assess expected risk reduction; and select and implement
mitigation method. The framework focuses primarily on risk retention, or using reserves, to manage
risk. However, the framework also encourages the City to think about how other risk management
methods might alleviate the need to retain risk. For example, perhaps a risk could be transferred by
The Origin of this Report
This report was originally developed as a consulting product for the City of Colorado Springs. The City graciously
gave the GFOA its permission to use the report for more general education and information sharing about risk-
based assessment of reserve requirements.
8
purchasing insurance or relying on another organization or accounting fund to manage the risk. It
might also be possible to avoid a risk by discontinuing activities that are creating a risk for the gen-
eral fund. Hence, a thorough examination of the risk factors should not only help lead to customized
reserve target size, but also should improve the City’s understanding of the risks it faces and its over-
all financial risk profile.
As a first step in this project, the GFOA conducted a basic review of the risk factors that generally in-
fluence the amount of reserves a municipal government should hold.9 This review enabled the City
and the GFOA to classify factors as either primary risks or as secondary risks. Exhibit 1.1 lists how the
risk factors were classified.
The next section presents an overview of the primary risk factors and the City’s level of exposure.
The third section reviews secondary risk factors that have less weighty implications for the City’s
general fund reserve strategy, but which still should be considered. The fourth and final section of
the report presents the findings of the analysis, including a customized target reserve level for the
City’s general fund and other ideas to improve the financial health of the City.
Exhibit 1.1
Categorization of Risk Factors that Influence Reserve Levels for Colorado Springs
Primary Risk Factors
Revenue (Sales Tax) Volatility
Infrastructure Upkeep
Vulnerability to Extreme Events and Public Safety Concerns
Secondary Risk Factors
Leverage
Expenditure Volatility
Liquidity/Cash Flow
Growth of the Community
9
2. Primary Risk Factor Analysis
This section presents the three most important risk factors examined by the GFOA and the City’s ex-
posure: the volatility of the City’s revenue portfolio, maintenance/replacement of the City’s infra-
structure (focusing on bridges and storm sewers), and vulnerability to extreme events and public
safety concerns.
REVENUE SOURCE STABILITY
Volatile revenue sources call for a higher reserve level in order to avoid the need for sudden service
cutbacks should revenues drop unexpectedly. Some revenues are inherently volatile. The sales tax is
usually considered to be a volatile revenue source because it is much more sensitive to swings in the
economy than a revenue source like the property tax, for instance. This is an important consideration
for Colorado Springs, considering that sales taxes (and the closely associated use tax) account for
over half of the general fund’s revenues.10 No other revenue source comprises more than a fifth of
general fund revenue (the next largest is transfers from other funds, at about 17 percent); the prop-
erty tax, normally a large revenue source for municipal governments, accounts for less than 10 per-
cent.
This section will first analyze the volatility of the sales tax, as well as two closely associated revenues
– the use tax and sales tax audit revenue. Following that, the stability of the general fund’s other im-
portant revenue sources will be examined.
Sales and Use Tax
A first step is to understand the level and nature of volatility in the sales tax. The sales tax appears to
follow fairly predictable seasonal patterns. Exhibit 2.1 shows annual sales tax revenues for 2007
through 2011 and Exhibit 2.2 shows monthly sales tax revenue since 2006.11 In Exhibit 2.1, use tax and
revenues from sales tax audits are removed. These revenues add “noise” to the pure sales tax data,
making it more difficult to analyze. They are also much smaller revenue sources – use tax is 7 percent
the size of sales tax and audit revenues are 3 percent of all sales tax revenue. These revenues will be
discussed later in the report.
Exhibit 2.1
Five-Year Trends for Sales Tax
2011 2010 2009 2008 2007
Revenue $111,735,533 $108,212,533 $101,247,887 $107,356,298 $113,211,788
Annual Change 3.3% 6.9% -5.7% -5.2% 1.7%
10
The red circles in Exhibit 2.2 denote January revenues, which are always the highest of the year due
to holiday shopping. The green circles show revenues from July, October, and April, which all see rev-
enue spikes (due to quarterly sales tax filings for smaller vendors). This pattern and even the relative
magnitude of the spikes are quite consistent from year to year, even as far back as 1996. In fact, a sta-
tistical analysis shows that only a 2 percent change in sales tax revenue is attributable to random
variation. About 91 percent is due to fundamental economic trends/business cycles (also known sim-
ply as “trend-cycle”), and 7 percent is explained by seasonal variation.12
This means that random fluctuations in the sales tax should not concern the City. However, it also
means that the influence of economic cycles is very strong. An unexpected shift in the economy
could have serious ramifications for City revenues, as the City has experienced in the wake of the
2001 recession and the more recent Great Recession. Exhibit 2.3 (on the following page) shows the
trend-cycle line for sales tax13 overlaid on monthly sales tax revenues. The red arrows show the begin-
ning and end-points of significant downtrends. The first one started in April 2001 and lasted until
May 2003. The trend-cycle declined 6.6 percent over 25 months, or about a quarter percent per
month. The second started in July 2007 and lasted until April 2009. The trend-cycle declined 11.2
percent, or just over half a percent per month.
Obviously, the decline associated with the Great Recession was much sharper than the 2001 reces-
sion, both in terms of overall decline and speed of the decline. In fact, so severe was some of the fi-
nancial fallout from the Great Recession that some have dubbed it what acclaimed financial thinker
Nasim Talib has termed a “Black Swan” event – a rare and unpredictable event that has an extreme
impact.14 Black Swans are, by definition, impossible to predict, so the best that anyone can do is to
be prepared. The accomplished forecasting scientist Spyros Makridakis has suggested a “Triple-A”
approach (described on the next page) for dealing with this kind of uncertainty.15
Exhibit 2.2
Seasonal Peaks in City Sales Tax Revenue
There are four consistent spikes in sales tax revenue during the year, with January being the most important. The other
spikes occur in July, October, and April.
11
1. Accept. First we must accept that we are subject to uncertainty. Even though the sales tax is
subject to relatively little random variation, it is clearly subject to Black Swans. Because it is
relatively easy to imagine scenarios that could cause the Colorado Springs economy to suffer
(e.g., European financial crisis, federal debt crisis, a significant reduction in military spending
due to federal budget shortfalls, etc.), we must also accept that the economy is subject to addi-
tional potentially dangerous unknowns that we cannot imagine.
2. Assess. Next we must assess the potential impact of the uncertainty. Past history can provide a
useful reference point. We saw earlier that a downturn in the trend-cycle has lasted as long as
25 months and has been as severe as a 0.53 percent monthly decline. The rate of decline is
more relevant to the discussion of general fund reserves because a more protracted decline
should be dealt with by restructuring the budget, not necessarily with continuous use of fund
balance. Even so, it is important to consider both.
3. Augment. The range of uncertainty we really face will almost always be greater than we assess it
to be, so we should augment that range. For example, we used the experience of the Great Re-
cession as a reference point for our worst-case monthly decline (0.53 percent). However, many
economists believe that the effects of the Great Recession would have been much worse had
the federal government not taken the actions that it did.16 Who is to say that continued grid-
lock in the federal political system (or other circumstances) won’t prevent an effective mitigat-
ing response to the next crisis? As a rule of thumb, Makridakis suggests doubling your range
of uncertainty if you have little historical data to rely on or multiplying it by 1.5 if you have
more. We have a good deal of data, so a 1.5 multiplier seems appropriate, giving us a 0.8 per-
cent monthly decline. That translates to a potential 20 percent decline over 25 months. This
does not necessarily mean that the City should reserve this entire amount, though, because
Exhibit 2.3
Sales Tax Monthly Revenue and Trend-Cycle
The City has experienced two major downturns in the sales tax trend-cycle. The first one started in April 2001 and lasted until
May 2003. The trend-cycle declined 6.6 percent over 25 months. The second started in July 2007 and lasted until April 2009.
The trend-cycle declined 11.2 percent.
12
presumably, in the event of a financial Black Swan, the City would take action to reduce
spending – not just continue to spend as it had before. The implications of the sales tax analy-
sis, along with the other analyses performed by the GFOA, for the City’s reserve strategy will
be addressed in the fourth section of this report.
As mentioned earlier, audit revenues were removed from the sales tax data for purposes of this analy-
sis. As Exhibit 2.4 shows, from 2007 through 2011, audit revenues ranged between $3.3 million and
$2.2 million. It has experienced some fairly significant swings in this time as well. However, a $1 mil-
lion potential for variation is probably not material in the entire City revenue portfolio. The City ex-
pects sales tax audit revenues to continue into the future within the same general range that they
have occurred in the past.
Use taxes were also removed from the sales tax data. Exhibit 2.5 (on the following page) shows the
five-year trend analysis for use taxes. Use taxes are not quite as volatile as audit revenues, but are still
rather volatile. In fact, GFOA’s statistical analysis showed that almost 15 percent of the variation in
use tax is attributable to simple randomness (compared to 2 percent for sales tax). However, more
importantly, the use tax has experienced a notable decline since 2008. Examination of the long-term
history shows that the revenue experienced a rapid increase in 2005, coinciding with the construc-
tion boom and use taxes from commercial construction and manufacturing equipment. Revenue
stayed at about this level until 2008, when tax revenue declined considerably as these industries ex-
perienced a slowdown in their growth. Hence, the change we see in Exhibit 2.5 is less a product of
random variation and more a product of a fundamental change in the tax base. Hence, use taxes have
likely settled in at a new, lower level of yield that is reflective of reduced economic activity in com-
mercial construction and manufacturing equipment (in fact, the lowest level since 1996). As such,
there is probably little risk of another significant downside move.17 In fact, an analysis of the sources
of the use tax shows that income from construction-related trades has fallen substantially in recent
years. For example, revenue from building general contractors in 2011 was 12 percent of what it was in
2007, and revenue from subcontractors was 27 percent of 2007 levels. Also, total vacancy rates for
commercial properties have hovered around 10 percent for the last two years, up from 7.7 percent in
2008. This indicates that there may be excess capacity in Colorado Springs, such that a significant
uptick in building is not likely in the near term.
Sales Tax Point of Comparison
Appendix 1 provides a similar analysis of monthly sales tax data from the City of Boulder, Colorado, in order to
provide a sense of context for how volatile sales tax revenue is in another jurisdiction.
Exhibit 2.4
Five-Year Trends for Sales Tax Audit Revenue
2011 2010 2009 2008 2007
Revenue $3,284,390 $2,369,723 $3,250,245 $2,189,116 $2,210,099
Annual Change 32.8% -27.1% 48.5% -0.9% 51.3%
13
While sales tax is clearly the most important revenue, an analysis of reserve requirements should
take account of other revenues as well, given that other revenues comprise half of the City’s budget.
Below is a summary of other major sources of revenue and their associated volatility risk.
Property Taxes. Property taxes comprise only about 9 to 10 percent of the City’s budget. The City has
experienced a steady decline in property tax revenues in recent years, with a primary cause being a
reassessment and lower property values owing to the decline in the housing market. Nationally, the
housing market seems to have stabilized, at least to the point where another major decline is un-
likely.18 An examination of Colorado Springs’ housing prices shows that Colorado Springs seems to
essentially follow national trends.19
Charges for Service. Charges for service are about 6 to 7 percent of the general fund budget. Revenues
from charges for service have fallen substantially in recent years, now budgeted at 70 percent of the
2009 actual revenues. This is mostly due to a sharp decline in charges for services for
construction/development regulation. Hence, the user fees do have some vulnerability to economic
cycles. A reserve could be useful, but the City might also consider other policies to mitigate risk. For
example, a policy that sets cost recovery goals for fees would prompt a discussion of how to reduce
costs if revenues were not up to expectations. Regardless, it may be helpful to have a small reserve in
order to allow gradual adjustments to drop-offs in revenues. In recent history, the total charges for
service revenues have dropped $3 million in one year. At this point, fees that are more sensitive to
economic conditions (e.g., construction-related fees) have probably reached or are approaching a
bottom. Accordingly, a $3 million reserve should probably be more than adequate.
Intergovernmental Revenue. Intergovernmental revenue is about 9 to 10 percent of the general fund
budget. By far, the most important component of this is the highway users tax, at about 90 percent of
the total. The highway users tax is intended to support traffic safety and road maintenance programs.
There has been political pressure at the state level to reduce the resources that support the tax, but,
so far, this has not happened. However, if one of these efforts were successful the City would find it-
self with reduced revenue. City staff believes that the Funding Advancements for Surface Trans-
portation and Economic Recovery (FASTER) portion of the highway users tax is the most vulnerable
to being eliminated (about $1.5 million), so reserve strategy could focus on replacing that amount for
one year (after which point the City would presumably have adapted).
The City also receives a number of grants for capital projects, and some for operations. These grants
are not accounted for in the general fund, but if the grants were to be lost there could be some pres-
sure on the general fund to continue the associated service. For capital projects, the City would likely
cancel or defer the project or find another source of funding, rather than using reserve to make up
the shortfall from a lost grant. Lost grants for operations may require some support from the general
fund in order to provide continuity in service (assuming the City cannot simply discontinue the serv-
ice). A reserve of $3 million appears to be adequate to cover this risk, based on the level of grants
used to support core operating programs currently.
Exhibit 2.5
Five-Year Trends for Use Tax
2011 2010 2009 2008 2007$
Revenue $6,024,785 $6,454,560 $5,668,451 $8,490,105 $9,264,952
Annual Change -6.7% 13.9% -33.2% -8.4% -12.4%
14
Transfers from Other Funds. The City receives about 17 percent of its revenue from transfers from
other funds (from City utilities). This transfer is a matter of City Council policy. There do not appear
to be any major threats to the continued economic viability of this policy, so any change would have a
political genesis. A decision to reduce the transfer should be made in the context of how it will im-
pact the budget, so a reserve should not be necessary.
INFRASTRUCTURE
Healthy infrastructure makes for an economically vital community. However, worn infrastructure
poses a potential risk of untimely failure. General fund reserves may be needed to repair or replace
an asset that fails unexpectedly. In Colorado Springs, the two asset classes that were deemed to be of
the greatest importance are bridges and storm sewers.
Exhibit 2.6 shows a risk profile for bridges and culverts. Risk is defined as the product of probability
of failure and the consequences of failure. Probability of failure is based on the bridge sufficiency
index (BSI) provided by the City staff. A lower BSI indicates a bridge that is in worse condition and
ultimately a higher risk (probability) to fail. Consequence is based on cost – the higher the replace-
ment cost of an asset, the higher the consequence to the City if that asset were to fail.20 As can be
seen in the exhibit, 13 bridge structures have been identified as having a high risk rating (those
bridges in the red area, which have a total score of between 8 and 10, when the scores from each axis
are added together). These bridges have an estimated replacement value of $22,752,672. This aver-
ages to about $1.75 million per bridge. A reserve that covers one or two bridges should be adequate,
Exhibit 2.6
Risk Profile for Bridges and Culverts
Grant Policy
The City auditors have pointed out that overreliance on grants is a potential risk for the City. A policy that limits
the City’s exposure to the risky elements of grants could be helpful. Section 4 of this report describes how grant
policies might be helpful.
15
but using the “Triple-A” rule (described earlier) of doubling our expectation for uncertainty, prepar-
ing for the premature failure of three of these bridges might be more prudent. This equates to a $5.25
million reserve.
In addition to the bridges and culverts, the City manages 406 miles of storm lines. However, neither
install dates nor condition assessments were available for any storm lines. The estimated replace-
ment cost for all storm sewers is $588,052,836.21 Since the information necessary to assess risk of fail-
ure is not available, the best that can be done is to make an assumption. We do know that about 10
percent of the total dollar value of the City’s bridge inventory is in the higher risk category, so it may
be reasonable to start with that number for storm sewers, which would translate to $58 million. We
also know that about 20 percent high risk category of bridges was recommended as a reserve
amount, which would equate to $11.6 million.
We will review how this analysis for bridges and storm sewers fits into an overall reserve strategy in
Section 4 of this report.
VULNERABILITY TO EXTREME EVENTS AND PUBLIC SAFETY CONCERNS
This factor concerns the extreme events (e.g., natural disasters) the City is vulnerable to, the public
safety programs that must be funded during the occurrence of an extreme event, and the federal or
state programs that would help and how long it would take to get assistance. For example, reim-
bursement from the Federal Emergency Management Agency (FEMA) does not always occur right
away, so it is important to have reserves to absorb the cost in the meantime, and FEMA does not nec-
essarily reimburse 100 percent of the cost of responding to an event.
Discussions with the City’s Emergency Operations Manager reveal that Colorado Springs is most at
risk for wildfires and floods. Wildfires are probably the most important risk, as the fires of 2012 un-
derlined. About 20-25 percent of homes in Colorado Springs are subject to wildfire risk, although
fires that damage homes are not that common. The most recent fire was the most destructive in Col-
orado history. It impacted around 12,000 acres and burned 347 homes. By comparison, the most re-
cent other fires of an extreme size were in 2005 and 2000 and impacted 35 and 800 acres,
respectively. No homes were burned in either of those fires – in fact, one must look back to around
1950 to find the last time before 2012 that homes in the City of Colorado Springs were burned by
wildfire.
Large wild fires can be expensive to respond to, requiring police and fire personnel for suppression of
the fire and evacuation of people. Many other city departments are involved in the recovery efforts.
FEMA reimbursement is not immediate and does not typically cover all the City’s costs of respond-
ing. Further, a fire is likely to interrupt the City’s sales tax revenue.
Currently, the City only has estimated costs for the most recent fire, which is $3.75 million in person-
nel time, mutual aid costs, and other direct expenses. The estimate pertains to the actual firefighting
within the City limits and the emergency protective measures taken (e.g., evacuation, security, acti-
vation of the emergency operations center, etc.). Of this, the expenses eligible for a 75 percent FEMA
reimbursement are estimated to be $2.15 million. Adding together the FEMA ineligible expenses,
plus the 25 percent unreimbursed expenses results in a figure of $2.14 million. At least some of this
represents expenses that the City would have incurred anyhow (e.g., firefighters on duty). The City
government did not incur any significant direct property damage as a result of the fire (probably
around $30,000), but there may be some indirect damage to storm sewers later on, as a result of in-
creased run-off, from the fire-damaged areas. The City engages in mitigation efforts, such as defor-
estation of areas that are at risk for wildfire, but it is still important for the City to retain a reserve to
be prepared for future wildfires.
16
Floods are also a concern because they damage infrastructure, require a City emergency response,
and require debris removal afterwards. The most severe floods were in 1935 and 1965. Otherwise,
smaller floods occur about 6 or 7 times in a 10-year period. The last flood that qualified as a FEMA
disaster occurred in 1999, though it wasn’t on the scale of the 1965 or 1935 floods. The cost to the City
to address the flood damage of 1999 was $2,670,158. The federal share of the project was 75 percent,
or $2,002,619; the state share was 12.5 percent, or $333,770; and the City share was the remaining 12.5
percent, or $333,770. This would equate to about $3.67 million in total costs and $460,000 for the
City’s final share in today’s dollars.
Blizzards represent a final, less severe risk. The magnitude of impact is not as great as for fires or
floods, but the City still incurs an unexpected cost. The last significant cost was in 2007, when the
City needed to appropriate an additional $400,000 to deal with snow storms.
In summary, Colorado Springs faces a risk from several types of extreme events that have the poten-
tial to cause loss of life and property and to disrupt business. The City has taken steps to protect the
health, safety, and welfare of the community in light of these risks. Fortunately, however, these ex-
treme events do not appear to constitute a large risk to the City’s financial position. For example, a
reserve of $4 million (compared to annual City revenues of about $220 million) would be more than
adequate to cover the cost of either the most recent fire or a flood of similar severity to the 1999
flood, before FEMA reimbursement.
However, using Makridakis’s “Triple-A” approach (described earlier), it may behoove the City to aug-
ment the level of risk it is preparing for. We have a very limited number of data points to inform us,
so a higher multiplier seems appropriate. If we multiplied $3.75 million by 2 we would get $7.5 mil-
lion. However, much of an extreme event’s cost would be reimbursed by other parties (e.g., a 75 per-
cent reimbursement from FEMA) and some of this figure would represent costs the City would incur
anyhow (e.g., regular salaries for public safety personnel), so a $7.5 million reserve might be exces-
sive. Discussions with City staff indicated that the City would have incurred about one third of the
most recent fire’s costs in the normal cost of doing business, and that about half of the reimburse-
ment from FEMA can be expected to be received within six months of the expenditure. Using this as
a reference point, a reserve of $3.3 million might represent the minimum prudent reserve amount
because it accounts for the fact that the City will have to bear some of the costs of responding to an
extreme event in its regular budget, and that another significant portion of the cost will be reim-
bursed quickly by FEMA. A reserve of $5 million might be a middle ground because it does not ac-
count for FEMA reimbursement (which is outside the control of the City).
Section 3 will consider the all the foregoing analyses together in order to present a final recom-
mended reserve target for the City.
17
3. Secondary Risk Factor Analysis
This section presents an overview of risk factors that are less complex or of lower magnitude than the
primary risk factors, but that also have implications for the City’s general fund reserve strategy.
LEVERAGE
A highly leveraged organization has less flexibility. Examples of leverage include long-term debt,
pension obligations, and obligations for post-employment health care. Reserves are a critical source
of financial flexibility, so high leverage may call for higher reserves. This section will address each of
the aforementioned sources of leverage.
Debt
The City has very little debt. Exhibit 3.1 demonstrates this by comparing the City’s level of indebted-
ness to other cities. Exhibit 3.1 includes a group of cities that Colorado Springs has identified as “Best
in Class” for the purpose of comparing the City’s business practices to those of other, similar cities.
Exhibit 3.1 also includes two “sales tax comparable” cities – Colorado cities that receive a large por-
tion of their revenue from sales taxes, but are not otherwise as similar to Colorado Springs. Finally,
the exhibit provides summary statistics of all these municipalities. Exhibit 3.1 compares debt along
Exhibit 3.1
Comparison of Colorado Springs’ Indebtedness with Other Cities
“Best in Class Cities”
Colorado Fort Collins Oklahoma Denver Indianapolis Charlotte
Springs City
Population 422,816 144,875 580,000 619,968 820,445 731,424
Debt per Capita 256 342 1,072 2,702 1,445 1,829
Debt Service as a
% of Expenditures 5.9% 3.5% 10.2% 10% 13.8% 15.2%
Sales Tax Comparables Summary Statistics
Colorado Lone Tree Centennial Average Median
Springs
Population 422,816 11.097 100,377 553,255 599,984
Debt per Capita 256 2,558 28 1,274 1,258
Debt Service as a
% of Expenditures 5.9% 10.4% 0.3% 9.8% 10.1%
The City has substantially lower debt levels than the average of the comparison group.
18
two commonly used measures of indebtedness. The first, debt per capita, measures the burden
placed on citizens by municipal indebtedness. The second measure is debt service (principal and in-
terest payments) as a percent of city expenditures. This figure measures the pressure placed on the
budget by debt payments. Colorado Springs is well below the average on both of these measures.
This means that Colorado Springs should not find its financial flexibility reduced by excess debt. In
fact, the City’s debt capacity could offer an alternative source of financial flexibility. For example, if
the City were found liable for an exceedingly large judgment that was due immediately, it might be
able to use debt instruments to pay the amount over time.
The reader should note that the GFOA did not use only the general fund financial information to cal-
culate these ratios, but rather used the broader categories of “governmental activities” and “govern-
mental funds,” which can be found in any comprehensive annual financial report. This is because all
the cities accounted for debt in different funds, so looking at just the general fund would provide a
partial, and inaccurate, impression. However, the aforementioned categories have fairly standard
meanings across government and they include most of the general government services one would
typically associate with a municipality, such as public safety and public works. Therefore, they ad-
dress debt of a general nature, which does have direct relevance to the financial flexibility of the gen-
eral fund.
These general government categories, though, exclude utilities and other more business-like activi-
ties. The business-like category of services was excluded for two main reasons. First, municipalities
do not provide these types of services as consistently as they do general government services. Second,
these services, particularly utilities, often carry large amounts of debt, and would therefore have had
a major impact on the indebtedness measures. However, this debt has a much more indirect rela-
tionship to the financial flexibility of the general fund.
Pensions
The City is involved in four different self-funded pension arrangements, all of which are closed to
new participants.
• The Old Hire Police Pension Fund has been closed and has 166 total members. The plan is 81
percent funded as of January 1, 2012. GFOA Best Practices call for 100 percent funding of pen-
sion liabilities.22 The plan has an unfunded liability of $16.1 million, which translates into an
annual actuarial required contribution (ARC) of $1.5 million for 2013, up from $1.4 million in
2012.
• The New Hire Pension Plan – Police Component has 650 members and a funded ratio of 80.2
percent. The plan has an unfunded liability of $48.8 million, which translates into an annual
ARC of $10.6 million for 2013, up from $9.6 million in 2012.
• The Old Hire Fire Pension Fund has 193 members and is 84.1 percent funded. The plan has an
unfunded liability of $15.5 million, which translates into an annual ARC of $1.5 million for 2013,
which is about the same as 2012.
• The New Hire Pension Plan – Fire Component has 286 members and is 79.2 percent funded.
The plan has an unfunded liability of $25.9 million, which translates into an annual ARC of $4.7
million for 2013, which is down from $ 5.2 million in 2012.
The City also participates in two statewide plans. The Colorado Public Employees Retirement Associ-
ation for is for civilian employees. As of December 31, 2011, the PERA Local Government Division’s
funded ratio was 69.3 percent, with an unfunded liability of $1.277 billion. Of course, this underfund-
ing could have some impact on the City in the form of increased contribution rates in the future. The
Fire and Police Pension Association of Colorado provides a defined benefit plan for sworn officers. It
is funded at over 100 percent as of January 1, 2011.
19
Another issue common to all pension funds is the assumed rate of return on pension fund assets.
Pension funds often assume return rates of around 7 to 8 percent annually. The recent performance
of investment markets has led some to question the return assumptions the Colorado Public Em-
ployees Retirement Association uses. If circumstances were to require the association to lower its re-
turn assumptions, then member governments would have to increase contributions to make up the
difference.23
Assuming that the City keeps up with its ARC payments, the unfunded accrued liabilities should, in
theory,24 be covered by the end of the amortization period (which can vary with the plan, but typi-
cally is between 20 and 30 years). Keeping up with the ARC payments is a matter of City budgetary
policy, and not really an issue that should be addressed through using reserves. However, given the
uncertainty around pension issues, it is difficult to say when increases would occur or how much
they might be. Accordingly, it would be prudent to hold some reserve to help make a more gradual
adjustment to any potential large increases in contribution rates. The City currently pays about $10.5
million in annual contributions to the Colorado Public Employees Retirement Association and about
$14.5 million to the other pensions, for total of about $25 million. A reserve of $6.25 million would
cover a 25 percent increase in pension costs. Of course, an increase in the City’s contribution would
be felt over many years, but the reserve will allow the City to make a gradual adjustment or to more
easily absorb a larger increase in contributions in one year.
The City has considered different actions to mitigate its pension liabilities, including increasing the
contributions required from employees and switching to a defined contribution pension plan. It has
also shifted away from a single-employer plan to the state plan for the most newly hired sworn offi-
cers, which should be less volatile and help mitigate risk.
Other Post-Employment Benefits (OPEB)
The City allows retired sworn police officers to stay on a City-sponsored medical plan. The cost of
this benefit is paid for by the City as it is incurred. The City’s annual required contribution for OPEB
is $2.2 million and there is a net obligation of $11.2 million. The City has taken steps to contain its
OPEB liability, such as eliminating the City-provided subsidy for retiree health care for new hires and
going to a flat (instead of variable) subsidy for existing employees. Hence, similar to pensions, the
City will likely not experience near-term, large expenditure spikes or a drastic decrease in the City’s
financial flexibility owing to OPEB liabilities. Also, like pensions, the financial pressure created by
OPEB liabilities is best addressed through the budget process, not general fund reserves.
EXPENDITURE VOLATILITY
This risk factor refers to potential spikes in expenditure, usually arising from a special, non-recurring
circumstance. Expenditures of a recurring nature should not be addressed through the use of re-
serves, since reserves do not represent a sustainable source of funding for recurring expenditures.
Rather, recurring expenditures should be accommodated in the operating budget.
In Colorado Springs, lawsuits appear to be the most important potential source of expenditure
spikes, especially because the City’s risk management funds do not carry a large amount of reserves
themselves, requiring the general fund to backstop them.
Discussions with the City’s attorney and risk management professional reveal the following:
• The City faces a number of litigation cases each year. The average potential liability tends to be
pretty consistent from year to year. The City normally budgets between $600,000 and $800,000
each year for claims, which generally has proven sufficient. In more recent years, the number of
litigation cases has risen somewhat, but this does not appear to be a significant trend.
20
• The City is a facing a couple of extraordinary special cases. Due to the sensitivity of the cases,
they will not be discussed in detail in this report, but there is a significant degree of uncer-
tainty around the amount the City could be liable for and if the City will be liable for anything
at all. Hypothetically, the liability could represent tens of millions of dollars, but the City At-
torney believes that an amount of between $2 million and $4 million is a more realistic esti-
mate of the City’s potential risk. Also, under certain circumstances the City could negotiate a
multi-year payment schedule for a large liability.
• In the State of Colorado, certain forms of cancer have been designated as work-related injuries
for firefighters. Hence, the City’s worker’s compensation fund will face an increased liability,
which will, in part, be covered by the general fund (since the general fund is one of the con-
tributing funds to the worker’s compensation fund). This would not create an expenditure
spike, but rather would manifest as an increased annual contribution (probably not to exceed
$1 million to $2 million per year). Accordingly, this change to the City’ recurring expenditure
structure should be handled through the City’s budget process.
In conclusion, it would seem prudent for the City to account for at least some of the risk associated
with the extraordinary lawsuits in its reserves. The final section of this report will address how this
risk fits in with the City’s total reserve goals.
GROWTH OF THE COMMUNITY
Rapid growth of the community could call for larger levels of reserves, lest service requirements ex-
pand beyond the City’s ability to continue services in the face of revenue interruption. For instance,
property tax revenues may not be received until a couple of years after development occurs, yet the
government will still need to provide for the public safety, health, and welfare of these members of
the community in the meantime. Colorado Springs is a moderate growth community in a higher
growth region. The City averages 1.5 percent growth in a region that grows 2 percent annually. The
City does not rely heavily on property taxes, so is not heavily impacted by a lag between when serv-
ices are required by a new development and when revenues are received. Also, the City requires de-
velopers to build much of the infrastructure associated with development (roads, parks, etc.), so it
does not have to cover that expense. In conclusion, the fact that Colorado Springs is only expecting
moderate growth in the next few years and that its development financing approach does not require
City resources for large capital outlays means that the implications of growth for the City’s reserves
are minimal.
LIQUIDITY
A larger amount of unreserved fund balance may be needed to avoid cash flow problems if the aver-
age maturity of receivables significantly exceeds the average maturity of payables. A common exam-
ple of this can be found in governments that are heavily reliant on property taxes. The bulk of taxes
may only be received at one or two times during the year, requiring reserves to bridge the months
with lower receipts. As stated, Colorado Springs is not very reliant on property taxes at all. In fact, its
revenue tends to come in fairly evenly over the year. Exhibit 3.2 (on the following page) shows the
projected monthly balances for 2012. As the chart shows, the City’s ending balance actually moves
steady upwards for almost the entire year, eventually dropping near the end (due to bond repay-
ments), but still ending up higher than it started. Hence, the City does not appear to have a liquidity
problem that requires reserves to cover the gap.
21
The City’s ending balances rise steadily throughout most of the year.
Exhibit 3.2
The City’s Projected Monthly Ending Balances for 2012
140,000,000
120,000,000
100,000,000
80,000,000
60,000,000
40,000,000
20,000,000
0
Ja
n
-
1
2
Fe
b
-
1
2
Ma
r
-
1
2
Ap
r
-
1
2
Ma
y
-
1
2
Ju
n
-
1
2
Ju
l
-
1
2
Au
g
-
1
2
Se
p
-
1
2
Oc
t
-
1
2
No
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-
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2
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-
1
2
22
4. Recommendations
This section provides GFOA’s recommendations to Colorado Springs, based on the analysis pre-
sented in this paper. The first sub-section addresses the primary purpose of this report: to recom-
mend a reserve target for Colorado Springs. The second sub-section provides other ideas related to
reserve management strategy that Colorado Springs might find helpful, based on GFOA’s experience
with best practices in public finance.
RECOMMENDED RESERVE TARGET FOR COLORADO SPRINGS
This section establishes the recommended reserve target for Colorado Springs. As a first step, the re-
port will review the essential findings of the analysis for each risk factor. Next, the report will provide
some helpful comparative information, such as the reserve levels maintained by other cities as well
as rating agency standards. Finally, all of this information will be synthesized to reach a reserve tar-
get.
Comparative Reserve Information
When considering a reserve target it is helpful to consult outside standards. Two widely cited stan-
dards are GFOA’s Best Practices and rating agency guidelines. The GFOA Best Practice 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 (16 percent) of regular general fund operat-
ing revenues or regular general fund operating expenditures.25 Standard & Poor’s considers reserves
of between 1 percent and 4 percent of revenues to be “adequate,” while reserves above 15 percent are
“very strong.”26
It is also useful to consider the experiences of other governments. Exhibit 4.1 compares Colorado
Springs’ unrestricted fund balances as a percent of general fund revenues to the same cities that ap-
peared in the debt comparison (Exhibit 3.1). “Unrestricted fund balance” is usually used to describe
the portion of fund balance that is available to serve as a reserve for the types of risk mitigation pur-
poses that were described in this report (i.e., respond to extreme events, protect against revenue
downturns, etc.). This is because unrestricted fund balance is the portion of fund balance that does
not have restrictions placed on its use by outside authorities.
23
As Exhibit 4.1 shows, the typical unrestricted fund balance falls somewhere in between 20 percent
and 25 percent of general fund revenues. Most of the cities in the analysis were closer to 20 percent,
but two outliers (Indianapolis and Centennial) pulled up the average.
The average level of unrestricted fund balance (i.e., reserves) falls between 20 percent and 25 percent
for the comparable group. Colorado Springs falls within this range right now. The outliers in the
comparable group (Indianapolis and Centennial) have special circumstances.
Indianapolis had a very large amount of “committed” fund balance, which is a subcategory of “unre-
stricted” fund balance. “Committed” fund balance is considered to be the most constrained of three
subcategories of unrestricted fund balance because the City’s management has committed those re-
serves for a very specific purpose (the other two subcategories are “assigned” and “unassigned”).
While it is impossible to say from Indianapolis’s public reports, it could be that this unusually large
amount has been accumulated to pay for a special project of some kind or is otherwise not intended
as a hedge against risk. In fact, if this amount is removed, Indianapolis’s reserve drops to 22 percent –
much more consistent with the other cities. None of the other cities had nearly as large an amount,
by any measure, of committed reserves. For example, 61 percent of Indianapolis’s reserves are com-
mitted, while Colorado Springs only has about 3 percent in this category and Denver has about 8 per-
cent, making Denver’s fund balances the most highly committed after Indianapolis.
As for Centennial, about 75 percent of Centennial’s reserves are in the “unassigned” subcategory (the
least constrained of the three), which suggests that Centennial has simply accumulated a much
higher relative level of reserves than the other governments in Exhibit 4.1. Interestingly, Centennial
also has, by far, the lowest debt burden of any of the cities (see Exhibit 3.1). This high reserve, cou-
pled with an extremely low debt burden suggests that Centennial has a significantly different eco-
nomic base than the other cities. For example, the median household income in Centennial is
$85,500, compared to $51,000 in Colorado Springs and $55,400 in the State of Colorado. The median
home value in Centennial is $260,000, compared to $182,000 in Colorado Springs and $205,000 in the
State of Colorado.27 In 2010, the unemployment rate in Centennial was 4.8 percent, compared to 9.4
percent in Colorado Springs. Although neither municipality relies very heavily on property taxes, it is
interesting to note that the total assessed value of properties in Centennial is 34 percent greater on a
per person basis than in Colorado Springs. Finally, Centennial’s general fund revenues are, on a per
capita basis, 20 percent greater than those of Colorado Springs, even though Centennial appears to
Exhibit 4.1
Unrestricted Fund Balance Comparison
“Best in Class Cities”
Colorado Fort Collins Oklahoma Denver Indianapolis Charlotte
Springs City
Unrestricted Fund Balance
as a % of Revenues 22.6% 23.1% 12.7% 18.3% 56.9% 17.3%
Sales Tax Comparables Summary Statistics
Colorado Lone Tree Centennial Average Median
Springs
Unrestricted Fund Balance
as a% of Revenues 22.6% 29.6% 52.9% 25.2% 20.5%
The average level of unrestricted fund balance (i.e., reserves) falls between 20 percent and 25 percent for the comparable
group. Colorado Springs falls within this range right now. The outliers in the comparable group (Indianapolis and Centennial)
have special circumstances.
24
provide a more limited set of services to its citizens (for example, Centennial is served by a separate
fire protection district and recreation district, while Colorado Springs provides these service di-
rectly). These distinctive characteristics have likely made it more practical for Centennial to accumu-
late a sizable reserve.
Putting it All Together: The Reserve Recommendation
In order to reach the final recommendation for a reserve target for Colorado Springs, let’s first review
the individual analysis results from each of the risk factors.
Primary Risk Factor – Revenue (Sales Tax) Volatility. While the sales tax does show some volatility, this
is due almost entirely to economic cycles and seasonal effects (as opposed to random variation).
Therefore, the most important vulnerability the City has with respect to sales taxes is an economic
downturn. A review of past economic downturns leads us to believe that the City should prepare for
a potential 20 percent decline in sales tax revenues over 25 months as a plausible “worst case sce-
nario” (this amounts to about $23 million in reduced revenue). However, the City would presumably
reduce its spending in the event of such a severe downturn, such that a reserve to cover the entire
amount of the revenue decline would not be necessary. The City budget office estimates that the
budget could be reduced by just under $10 million without creating a major disruption to services
(though service quality would be negatively affected to some degree, of course). This means the City
should maintain a reserve of at least $13 million to fill the remaining portion of the revenue gap and
to help the City make a “soft landing” in the case of a major revenue decline.
The City’s other revenue sources are fairly stable as a group, but as a prudent measure the GFOA has
recommended establishing some reserves to account for volatility. These reserves added up to $7.3
million.
Primary Risk Factor – Infrastructure. General fund reserves may be needed to repair or replace an asset
that fails unexpectedly. In Colorado Springs, the two asset classes that were deemed to be of the
greatest importance are bridges and storm sewers.
Thirteen bridge structures have been identified as having a high risk rating. These bridges have an
estimated replacement value of $22,752,672, an average of about $1.75 million per bridge. A reserve
that covers one or two bridges should be adequate; it might be more prudent, however, to use the
“Triple-A” rule of doubling our expectation for uncertainty and prepare for the premature failure of
three of these bridges. This equates to a $5.25 million reserve.
The City manages 406 miles of storm lines. Installation dates and condition assessments were un-
available for any storm lines. The estimated replacement cost for all storm sewers is $588,052,836.28
Since the information necessary to assess risk of failure is not available, the best that can be done is
to make an assumption. We do know that about 10 percent of the total dollar value of the City’s
bridge inventory is in the higher risk category, so it may be reasonable to start with that number for
storm sewers, which would translate to $58 million. We also know that about 20 percent high risk
category of bridges was recommended as a reserve amount, which would equate to $11.6 million.
Primary Risk Factor – Vulnerability to Extreme Events. Although the City is subject to extreme events
that pose a significant threat to life and property, historical experience has demonstrated that the fi-
nancial impacts of these events have been manageable. For example, the most recent fire was the
worst in Colorado history, but the total cost to the City was only $3.75 million (the City’s annual
budget is about $220 million). Taking into account the uncertainty associated with the scale of future
extreme events as well, as well as the timing of FEMA reimbursement and the portion of event re-
sponse costs that are likely going to be already covered by existing budgeted resources a reserve for
extreme events of $5 million seems reasonable, but an argument for a reserve of up to $7.5 million
could also be made.
25
Secondary Risk Factor – Leverage. The City has very little debt, so the City’s reserve strategy does not
need to account for reduced financial flexibility from debt.
The City has some financial pressure from pension obligations. It participates in a number of plans,
none of which is 100 percent funded. The Colorado Public Employees Retirement Association is a
particular concern for City officials because it has a low funding ratio and its assumptions around the
return on plan assets have been publicly questioned for being too high. Both of these factors mean
that the Association may require significantly increased contributions from its member govern-
ments.
Assuming that the City keeps up with its annual pension payments, the unfunded accrued liabilities
should, in theory, be covered by the end of the amortization period (which can vary with the plan,
but typically is between 20 and 30 years). Keeping up with the ARC payments is a matter of City
budgetary policy, and not really an issue that should be addressed through using reserves. However,
given the uncertainty around pension issues, it is difficult to say when increases would occur or how
much they might be. Accordingly, it would be prudent to hold some reserve to help make a more
gradual adjustment to any potential large increases in contribution rates. The City currently pays
about $10.5 million in annual contributions to the Colorado Public Employees Retirement Associa-
tion and about $14.5 million to the other pensions, for total of about $25 million. A reserve of $6.25
million would cover a 25 percent increase in pension costs. Of course, an increase in the City’s contri-
bution will be felt over many years, but the reserve will allow the City to make a gradual adjustment
or to more easily absorb a larger increase in contributions in one year.
Secondary Risk Factor – Expenditure Volatility. The City is facing a few large lawsuits that could entail
significant settlement costs if judgment goes against the City. The City attorney believes that $2 mil-
lion to $4 million is a reasonable range to prepare for.
Secondary Risk Factor – Liquidity/Cash Flow. The City faces no important liquidity or cash flow prob-
lems that create a shortage of working capital.
Secondary Risk Factor – Growth of the Community. The fact that Colorado Springs is only expecting
moderate growth in the next few years and that its development financing approach does not require
City resources for large capital outlays means that the implications of growth for the City’s reserves
are minimal.
In summary, the components of a recommended reserve are:
• $13 million for sales tax economic uncertainty
• $7.5 million for economic uncertainty in other revenues
• $6.25 million for pension payment uncertainty
• $5.25 million for critical bridge failure and $11.6 million critical storm sewer replacement, for a
total of $16.85 million
• $5 million to $7.5 million for extreme events
• $2 million to $4 million for expenditure spikes from law suits
Many cities express their reserve policy target as single number (e.g., 16 percent of revenues). How-
ever, the GFOA has found that leading municipalities often find it helpful to segment their reserves
into different categories because this makes the purpose of the reserve more transparent. For exam-
ple, a reserve for “emergencies” and a reserve for “economic uncertainty” would provide more clarity
on the purpose of the reserves than one all-encompassing reserve. The first three bullets above could
comprise the budgetary uncertainty reserve, while the last three would form the emergency reserve,
26
leading to the following targets (which have been rounded to the nearest whole numbers for ease of
use in policymaking):29
Budgetary Uncertainty Reserve
$13 million for sales tax economic uncertainty +
$7.5 million for economic uncertainty in other revenues +
$6.25 million for pension payment uncertainty =
$27 million or about 12.5% of general fund revenues30 as budgetary uncertainty reserve
Emergency Reserve
$5.25 million for critical bridge failure and $11.6 million critical storm sewer replacement, for a
total of $16.85 million +
$5-7.5 million for extreme events +
$2-4 million for expenditure spikes from lawsuits =
$27 million or about 12.5% of general fund revenues as an emergency reserve
This provides a target of about 25 percent of general fund revenues, which is also in line with the
range of reserves maintained by cities comparable to Colorado Springs and is above what the GFOA
considers to be the minimum baseline level that a government should maintain (16 percent).31 These
reserves would be considered part of the “unrestricted” portion of the City’s fund balance.32
OTHER IDEAS TO SUPPORT THE GENERAL FUND RESERVE STRATEGY
This section presents other ideas that Colorado Springs may wish to consider, relative to its reserve
strategy. These ideas include: enhanced sales tax monitoring, a user fee cost recovery policy, a
volatile revenue policy, a short-term borrowing policy, and a grants policy.
Sales Tax Monitoring
Because a potential decline in sales tax revenue is the major driver for the City’s need to retain re-
serves, it might consider additional methods to monitor the potential direction of its sales tax rev-
enue. The City already employs some fairly sophisticated long-range forecasting methods. It should
continue to refine these practices, and continue looking for leading indicators of sales tax perform-
ance. However, the GFOA did not conduct an in-depth examination of the City’s long-range forecast-
ing methods, so this report will focus on how some of the techniques presented in this paper might
be helpful going forward.
First, the City might monitor a 12-month, centered moving average, updating it each month. As Ex-
hibit 2.3 demonstrated, the 12-month moving average reveals long-term trends that are not as readily
apparent from monthly data, especially when month-to-month fluctuations are so dramatic (even if
the fluctuations are rather predictable). If the moving average starts to turn down, it could indicate a
real trend. Of course, the problem with this approach is that a moving average will always be five to
six months behind, since the analysis must wait for the historical data to become available. A more
immediately useful technique would be to compare monthly fluctuations to the average. If a month
that is normally a high-yield month does not come in as strong as expected or if a month with nor-
mally low yield is particularly bad, it could portend trouble. Exhibit 4.2 (on the following page)
shows how the months of the year compare to both the 12-month moving average and to the month
before it (e.g., how January compared to December, etc.). The month-to-month numbers are often
larger because revenues sometimes go from peak to valley and vice versa very quickly. The month-to-
month numbers will also be easier to use, because they don’t rely on the availability of moving aver-
age data.
27
User Fee Cost Recovery Policy
User fees represent about 6 percent of all general fund revenue. User fees are an increasingly popular
way to fund municipal services because they assign the cost of the service directly to the customer, as
opposed to the general taxpayer. The City could strengthen its user fee base by adopting an official
policy on the extent to which it will seek to recover the costs of providing services through a user fee.
A user fee cost recovery policy could be very detailed – setting precise targets for the percent of cost
to recover for different types of services.33 However, most governments take an approach that allows
for more discretion, where the policy establishes full recovery as the goal for user fees, but recognizes
that there will be occasional exceptions. This policy from Minneapolis, Minnesota, illustrates:
The city shall establish user charges and fees at a level that reflects the service costs… Full cost
charges shall be imposed unless it is determined that policy, legal, or market factors require lower fees.
This policy approach will require that it be decided, on a case-by-case basis, where subsidization of a
service with general tax dollars is appropriate.
User fees can be a complex and, sometimes, controversial revenue source. It may be helpful to estab-
lish a policy that describes the fundamental goals of user fees and a mechanism for regular fee re-
view. The GFOA has made available considerable detailed information on fee policies.34
Volatile Revenue Policy
As we have seen, the sales tax can be strongly influenced by the state of the economy. Just as an eco-
nomic downturn can depress sales taxes, a buoyant economy can lead to a rapid increase. This pres-
ents a financial risk if these new revenues are used to fund recurring expenditures (e.g., new
on-going programs and their associated personnel) and if these new revenues stem from an unsus-
tainable level of consumer spending. A volatile revenue policy encourages a government to examine
its past revenue trends to determine when it may next experience an anomalously high level of rev-
enue income, and then to apply this revenue toward non-recurring uses, such as paying off debt,
building up a reserve, or special projects that will reduce future operating costs.
Exhibit 4.2
Average Monthly Variations in Sales Tax Revenue
Average % Difference Average % of the
from Previous Month 12-Month Moving Average
January 35.7% 125.0%
February -33.8% 82.5%
March 3.1% 84.4%
April 22.1% 103.1%
May -10.9% 91.4%
June 7.8% 98.5%
July 15.2% 113.0%
August -8.2% 102.5%
September -0.3% 102.2%
October 5.6% 107.4%
November -8.0% 95.4%
December -4.5% 92.4%
28
The policy for the City and County of Denver, Colorado, illustrates this type of policy:
It is not prudent to allocate sales tax revenue that exceeds the normal growth rate (defined as the aver‐
age annual growth rate over the last ten years) to ongoing programs. Therefore, sales tax revenues
that exceed the normal growth rate should be used for one‐time expenditures or to increase reserves
for the inevitable economic downturns.
Short-term Borrowing Policy
As Exhibit 3.1 showed, the City has a very low level of debt. Debt can be a source of financial flexibil-
ity, thereby mitigating the need to hold reserves. Short-term debt could be useful if the City finds it-
self with the need for a temporary cash infusion (to deal with an unexpected situation). However,
short-term borrowing from external sources is usually considered undesirable due to, among other
things, the administrative costs of arranging the deal. Accordingly, a policy usually places limits on
short-term external borrowing. For example, a policy might specify that short-term instruments be
used only if the transaction costs plus interest of the short-term debt are less than the cost of inter-
nal financing and if available cash is insufficient to meet working capital requirements. A policy
could also state that short-term debt issued for operating purposes will be limited to cases where
there is reasonable certainty that a known revenue source will be received in the current fiscal year
sufficient to repay the debt, or where there is a clear financial emergency.
For many governments, interfund borrowing is preferred to external borrowing. For example, the
City’s utility may make a loan to the general fund or vice versa. This is another way to increase finan-
cial flexibility, beyond that provided by reserves. A policy for interfund loans is useful because, if not
carefully managed, the loans can become a cross-fund subsidization, which could lead to one group
of taxpayers or ratepayers subsidizing another group. A policy can establish terms and guidelines to
help avoid overly burdensome loans. The following are suggested elements for an internal loan pol-
icy:
Definition of a Loan vs. a Transfer. A policy should differentiate a loan from a transfer since the impli-
cations of each are different. Essentially, the difference is that operating transfers move financial re-
sources from one fund to another, permanently, while interfund borrowings are usually made for
temporary cash flow reasons and are not intended to result in a transfer of financial resources by the
end of the fiscal year.
Criteria for Making Loans. Just as a private lender would apply criteria to a potential borrower, a policy
should describe the general conditions under which an internal loan is permissible. A policy should
describe these conditions and designate the appropriate authority responsible for authorizing the
loan. Here are some examples of such conditions:
• The lending fund has funds available.
• The borrowing will not adversely impact the lending fund’s long-term financial condition.
• A specific source of repayment has been identified in the borrowing fund.
• The loan can be repaid within a specified period of time.
• Any legal requirements/restrictions are satisfied.
Interest Rates and Terms. A policy should also provide guidelines on terms and interest rates. Typi-
cally, interest rates would match prevailing rates, with the exact rate set by the finance office. For
long-term loans, a repayment schedule must be set, but the loan should typically be fully amortized,
preferably on a level or accelerated repayment schedule.
29
Grants Policy
Grants are an attractive form of funding for many local governments because they offer the possibil-
ity to reduce reliance on taxes and fees drawn from the community. On the other hand, grants can
harm the government’s long-term financial position if they lead to implementation of an ongoing
program that later requires support from general tax dollars when the grant expires. Further, many
grants require matching funds and overhead costs that might end up diverting funds from higher-
priority services. A policy can encourage grant-seeking, but should also recognize the risks of overre-
liance on grants and direct the organization to manage those risks. The policy from the City of Long
Beach, California, instructs staff to analyze the long-term costs and benefits of a grant before accept-
ing it:
City staff will seek out, apply for, and effectively administer federal, state, and other grants that ad‐
dress the city’s priorities and policy objectives and provide a positive benefit to the city. Before any
grant above $50,000 is pursued, staff shall provide a detailed pro‐forma to the city manager that ad‐
dresses the immediate and long‐term costs and benefits to the city. A pro‐forma must be submitted to
the city manager for all grants prior to accepting the grant award.
A policy should direct that any grants pursued are consistent with the government’s mission and
strategic priorities. Spotsylvania County’s policy states that “before applying for and accepting inter-
governmental aid, the county will assess the merits of a particular program as if it were funded with
local tax dollars.”
After the grant has been accepted, a policy should address the possibility that the grant will end,
leaving the government to decide whether to continue the program. Spotsylvania County’s policy
reads that “local tax dollars will not be used to make up for losses of intergovernmental aid without
first reviewing the program and its merits as a budgetary increment.”
Infrastructure Maintenance/Replacement Schedule
Rather than reserving funds to guard against the failure of worn assets, the City should develop a
plan and schedule to maintain and replace assets, as needed. Exhibit 4.3 (on the following page)
shows what yearly capital expenditures would be to keep up with bridge and culvert replacements.
Obviously, the pattern is quite volatile. The City might consider translating this into a regular sched-
ule, with a set annual contribution to funding that schedule. The GFOA estimates that a $10.9 mil-
lion approximate annual contribution would be necessary to fund the schedule. Not only would this
reduce the amount the City would have to hold in reserve (since assets would not deteriorate to criti-
cal condition), but it would greatly reduce the actual risk the City faces.
30
For storm sewers, the average annual contribution for a regular maintenance/replacement schedule would be about
$36 million, though this is a less precise figure because the underlying information on asset condition is not as detailed.
Exhibit 4.3:
Estimate of Annual Bridge and Culvert Replacement Costs
18,000,000
16,000,000
14,000,000
12,000,000
10,000,000
8,000,000
6,000,000
4,000,000
2,000,000
0
2012 2014 2016 2018 2020 2022 2024 2026 2028 2030
2013 2015 2017 2019 2021 2023 2025 2027 2029 2031
2032 2034 2036 2038 2040 2042 2044 2046 2048 2050
2033 2035 2037 2039 2041 2043 2045 2047 2049
18,000,000
16,000,000
14,000,000
12,000,000
10,000,000
8,000,000
6,000,000
4,000,000
2,000,000
0
Failure Cost
31
Appendix 1. Sales Tax Revenues in Boulder, Colorado
In order to provide a little better comparative context for examining Colorado Springs’ sales tax, the
GFOA requested permission from the City of Boulder to use its monthly sales tax data in a similar
analysis to Colorado Springs.’ Exhibit A1.1 shows Boulder’s revenues since June 2004. Like Colorado
Springs, Boulder has four “spikes” during the year, with a holiday spike being the largest. Boulder’s
sales tax revenue is a little more volatile, with about 4 percent of the variation attributable to random
factors.
Boulder also experienced a protracted decline in its trend-cycle in the wake of the Great Recession –
a 10 percent drop over 21 months. This is just under half a percent per month, not too different from
Colorado Springs.
Exhibit A1
Monthly Sales Tax Revenue from the City of Boulder, Colorado
32
1 The Triple-A approach is adapted from: Spyros Makridakis, Robin Hogarth, and Anil
Gaba. Dance with Chance: Making Luck Work for You (Oneworld Publications: Oxford, Eng-
land, 2009).
2 Drainage basins, open drainage features, discharge points, and point features are not in-
cluded in the replacement cost. Adding these items would likely push it to more than $1 bil-
lion.
3 Targets have been rounded to nearest “whole” numbers for ease of use in policymaking.
Also, see the main body of the report for a discussion of the independence of the risk factors
and the implication for sizing the reserve.
4 Based on the 2012 budget estimate of approximately $220 million in general fund revenue.
5 See the GFOA best practice, Appropriate Level of Unrestricted Fund Balance in the Gen-
eral Fund, available at www.gfoa.org. According to this best practice document, governments
should establish a formal policy of maintaining reserves equal to about 16 percent of rev-
enues or expenditures, and the actual target should be based on an analysis of the salient
risks the government faces – which in many cases calls for a reserve level of more than 16
percent.
6 TABOR, for example, limits the City’s ability to increase taxes.
7 GFOA Best Practice, “Appropriate Level of Unrestricted Fund Balance in the General
Fund” (2009).
8 Definition of risk taken from Douglas W. Hubbard, The Failure of Risk Management: Why
It’s Broken and How to Fix It (Hoboken, New Jersey: John Wiley and Sons, Inc., 2009).
9 The risk factors and basic review method were developed and published in: Shayne C.
Kavanagh, Financial Policies (Chicago: Government Finance Officers Association, 2012).
10 The use tax is much smaller than the sales tax – comprising only around 5 percent of the
total of the two.
11 This is City general fund only and excludes other sales tax revenues, such as the 2002
public safety sales tax (which is accounted for outside of the general fund, in a special rev-
enue fund).
12 The GFOA used a method of data de-seasonalization known as multiplicative decomposi-
tion to arrive at this conclusion.
13 The trend-cycle line is calculated by taking a 12-month centered moving average of ac-
tual monthly sales tax revenue. For example, the moving average for January 2005 would be
Endnotes
33
an average of August 2004 through July 2005. February 2005 would be an average of Septem-
ber 2004 through August 2005, and so on. A 12-month moving average smooths out seasonal
variation, leaving only the trend-cycle.
14 The term “Black Swan” derives from a belief held in England before 1697 that all swans
were white – in fact, the term “Black Swan” was a common metaphor for an impossibility.
Black swans were discovered in Australia in 1697, demonstrating the limits of human knowl-
edge about the world.
15 See Makridakis, Hogarth, and Gaba, Dance with Chance, 2009.
16 Of course, the long-term impacts of those actions are still unknown.
17 According to the Case-Shiller Housing Index, home prices nationally since 2009 have var-
ied in a range consistent with housing values in 2003. As of this writing, values have experi-
enced increases for six consecutive months.
18 According to David M. Blitzer, Chairman of the Index Committee at S&P Dow Jones In-
dices (which includes the Case-Shiller Housing Index), “the housing market seems to be stabi-
lizing, but we are definitely in a wait-and-see mode for the next few months.”
19 Based on sales prices from Zillow.com.
20 Note that further analysis could be conducted with City staff to refine asset replacement
costs, as well as reviewing the risk rating to incorporate more factors into the consequence
(i.e., traffic count, location, major structure, etc.).
21 Drainage basins, open drainage features, discharge points, and point features are not in-
cluded in the replacement cost, which would likely push it over $1 billion.
22 See GFOA Best Practice, “Sustainable Funding Practices of Defined Benefit Pension
Plans” (2009), www.gfoa.org. An 80 percent funded ratio is often cited as an acceptable fund-
ing benchmark, but this figure does not have a sound actuarial basis. See, for example, Gi-
rard Miller, “Pension Puffery,” www.governing.com. Miller does state that an 80 percent
funding ratio might be acceptable at the bottom of an investment market because the funded
ratio will presumably rise with the market. Conversely, though, the funded ratio should be
above 100 percent at the top of a market to protect against a fall.
23 On top of this, the City is leasing its hospital system, so the employees will no longer be
contributing to the Colorado Public Employees Retirement Association, which adds further un-
certainty to the City’s future pension position.
24 Even if all ARC payments are made, an employer could still end up with an unfunded lia-
bility at the end of the amortization period if the actuarial assumptions used to calculate the
ARC do not hold up (e.g., the rate of return on plan investments).
25 GFOA Best Practice, “Appropriate Level of Unrestricted Fund Balance in the General
Fund” (2009), www.gfoa.org.
26 David G. Hitchcock, Karl Jacob, and James Wiemken, Key General Obligation Ratio
Credit Ranges – Analysis vs. Reality (New York: Standard & Poor’s, 2008).
27 Based on values from Zillow.com.
28 Drainage basins, open drainage features, discharge points, and point features are not in-
cluded in the replacement cost, which would likely push it over $1 billion.
29 Note that many of the risks listed in the table can be considered “independent,” meaning
that the occurrence of one risk has little to do with the potential occurrence of another risk. For
example, the occurrence of an extreme event has little or nothing to do with whether the City
34
also experiences an increase in its pension payments. In these cases, there could be a justifi-
cation for holding less reserves than the total of the two numbers because it is rather unlikely
that the City will experience both of these problems at once. However, other risks are not in-
dependent. For example, an economic downturn that causes a reduction in sales tax revenue
would likely also impact other revenues, a natural disaster could make the City more likely to
experience a critical infrastructure failure, or a natural disaster could result in interruption to
sales tax revenue. Because the risk factors appear to have at least some level of significant
inter-dependency (a level which is difficult to know), the approach of adding the reserve com-
ponents together represents a conservative approach to sizing reserves for Colorado Springs.
This approach would leave the City without any exposure to risk arising from risk factor de-
pendency. Note that zero exposure to risk also means that the City will hold more reserves
that it will probably need at any one time.
30 Based on about $220 million general fund revenue, as per 2012 budget estimates.
31 See GFOA Best Practice, “Appropriate Level of Unrestricted Fund Balance in the General
Fund” (2009), www.gfoa.org. The Best Practice states that reserves equal to about 16 percent
of revenues or expenditures is the minimum a government should consider for its policy and
that the actual target that a government adopts should be based on an analysis of the salient
risks that a government faces (which in many cases may call for a higher reserve level than
16 percent).
32 Within the “unrestricted” portion of fund balance, the City could choose to locate the re-
serves within the “unassigned” or “committed” categories. Municipal governments typically
choose the unassigned category because the accounting requirements to place funds in the
committed category are more stringent (e.g., the commitment must be made by formal action
of the City Council and the language describing the conditions for using the reserves must
meet a high level of precision).
33 See for example, the policy of the City of San Luis Obispo, California, which is available
on the GFOA website at www.gfoa.org/finanicalpolicies.
34 See Kavanagh, Financial Policies, 2009.
City of Millbrae
Balance Sheet
Governmental Funds
June 30, 2017
Low and
Moderate Income Non-Major Total
Housing Asset Governmental Governmental
General Fund Funds Funds
ASSETS
Cash and investments 22,355,858$ 208,126$ 18,122,181$ 40,686,165$
Cash with fiscal agent - - 3,757 3,757
Receivables:
Taxes 1,600,937 - 97,623 1,698,560
Accounts - net 279,810 - 208,467 488,277
Accrued interest 181,876 - - 181,876
Due from other governmental agencies 852,432 - 16,488 868,920
Loans - 11,657,276 - 11,657,276
Due from other funds 25,527 - - 25,527
Prepaid items 1,473,046 - - 1,473,046
Land held for resale - 587,223 - 587,223
Total assets 26,769,486$ 12,452,625$ 18,448,516$ 57,670,627$
LIABILITIES AND FUND BALANCES
Liabilities:
Accounts payable and accrued payroll 1,793,653$ 45$ 690,467$ 2,484,165$
Deposits 225,486 - 166,928 392,414
Due to other funds - - 25,527 25,527
Unearned revenue 204,331 - 46,175 250,506
Total liabilities 2,223,470 45 929,097 3,152,612
Fund Balances:
Nonspendable 1,473,046 - 1,473,046
Restricted 12,452,580 17,351,440 29,804,020
Assigned 356,744 296,333 653,077
Unassigned 22,716,226 - (128,354) 22,587,872
Total fund balances 24,546,016 12,452,580 17,519,419 54,518,015
Total liabilities and fund balances 26,769,486$ 12,452,625$ 18,448,516$ 57,670,627$
See accompanying Notes to Basic Financial Statements.
Major Funds
32
Statement of Revenues, Expenditures and Changes in Fund Balances
Low and
Moderate Income Non-Major Total
General Housing Asset Governmental Governmental
Fund Fund Funds Funds
REVENUES:
Property tax 11,378,840$ -$ 632,076$ 12,010,916$
Sales tax 2,779,906 - - 2,779,906
Transient occupancy tax 8,031,917 - - 8,031,917
Franchise fees 1,186,264 - - 1,186,264
Other taxes 727,870 - 999,508 1,727,378
Licenses and permits 571,875 - 40,404 612,279
Charges for services 807,500 - 1,629,813 2,437,313
Fines and forfeitures 1,550,814 - - 1,550,814
Use of money and property 837,728 18,760 99,813 956,301
Grants and intergovernmental 812,825 - 142,518 955,343
Miscellaneous 624,343 - 1,102,690 1,727,033
- Total revenues 29,309,882 18,760 4,646,822 33,975,464
EXPENDITURES:
Current:
General government 3,744,848 - 3,009 3,747,857
Public safety 13,759,054 - - 13,759,054
Public works 2,603,344 - 1,178,748 3,782,092
Culture and recreation 1,646,587 - 1,542,882 3,189,469
Community development 2,278,617 - 572,045 2,850,662
Capital outlay 1,461,952 - 875,095 2,337,047
Debt service:-
Principal - - 1,417,000 1,417,000
Interest, and fiscal charges - - 479,177 479,177
Total expenditures 25,494,402 - 6,067,956 31,562,358
REVENUES OVER (UNDER) EXPENDITURES 3,815,480 18,760 (1,421,134) 2,413,106
OTHER FINANCING SOURCES (USES):
Proceeds from insurance - - 4,401,067 4,401,067
Transfers in 433,493 2,356 830,822 1,266,671
Transfers out (1,820,822) - (63,849) (1,884,671)
Total other financing sources (uses)(1,387,329) 2,356 5,168,040 3,783,067
Net change in fund balances 2,428,151 21,116 3,746,906 6,196,173
FUND BALANCES:
Beginning of year 22,117,865 12,431,464 13,772,513 48,321,842
End of year 24,546,016$ 12,452,580$ 17,519,419$ 54,518,015$
See accompanying Notes to Basic Financial Statements.
City of Millbrae
Governmental Funds
For the year ended June 30, 2017
Major Funds
34