Date: August 5, 2018
To: Council Finance Committee
From: Phil Koen and Jak Vannada
Subject: Response to Staff memo – Review of the Town’s preliminary total operating cash
Background
Let us immediately state why this is such an important topic. There is a real economic cost to holding excessive amounts of cash when the Town currently has over $51,000,000 in unfunded pension liabilities. Calpers charges the Town 7.375% on its unfunded pension liability. The Town is realizing approximately 1.71% on a blended basis on its invested cash. Therefore the Town is incurring a negative interest arbitrage of 5.54% per year as a result of poor capital allocation.
Stated another way, if the Town had paid down $7,000,000 of its unfunded liability 7 years ago, the Town would have ‘”saved” $3, 200,000 in interest charges! This is a real economic savings.
Given that the Town currently has over $76,000,000 in unrestricted cash, it is a worthy discussion to determine if some of this cash can be reallocated to pay down the unfunded pension liability. Proper capital allocation is critical. The Town is not a bank. It is the Town Council’s responsibility to insure that the Town has adequate levels of cash on hand to run the Town and that the people’s money has been properly allocated.
Discussion
The Staff has laid out in their memo the distribution of the Town’s cash by fund type. For sake of brevity we will be focusing our comments at the fund level rather than the sub-fund since money can be more easily analyzed at this level.
Our comments will be directed to the General Fund, the Capital Projects Fund and Internal Services Funds. Based on the Staff’s memo these funds collectively hold $74.4m in cash as of June 30, 2018. Additionally all of this cash is legally unrestricted and freely available to the Town Council. The Town Council by administrative action can commit and spend these funds on any legal expenditure.
General Fund – $38.5m
Background
The General Fund is the primary operating fund of the Town. It accounts for all financial resources except those required to be accounted for in another fund. Based on the Staff’s report, as of June 30, 2018 there is approximately $38.5m of cash held in the General Fund. The question before us is, does this level represent an excessive level of cash and how do we determine that?
Analysis
One way to answer this question this is to look at the ratio of cash balance as a percentage of total operating revenues. This is a key metric that Moody’s Investor Service uses in evaluating the cash efficiency of all US cities that Moody’s covers.
Using the FY 2017 CAFR as our source of financial data, the General Fund had $36.0m in unrestricted cash on hand as of June 30, 2017. In FY 2017 the General Fund recorded $38.7m in revenue primarily from taxes and fees. Dividing the cash on hand by the revenue we get 93%. Compare that to the US Median reported by Moody’s of 35.4% or two neighboring cities that are most similar to the Town, Saratoga (63.9%) and Campbell (57.5%).
Clearly, when compared to other cities of like scale, the Town of Los Gatos has an outsized amount of cash on hand. Why is this?
The policy of the Town to carry larger “rainy day” reserves partially drives this result. We are pleased to see that the Staff agrees with our earlier statement that the GFOA recommended minimum required “rainy day” fund should be two months (16.6%) of operating revenues or expenditures (http://gfoa.org/fund-balance-guidelines-general-fund ).
Our analysis of surrounding cities of similar size tell us that the size of these rainy day funds most likely fall between 15% and 23% of operating expenditures (excluding transfers out). We tried to find other cities in California that carry reserves “equal to three or four months of budgeted General Fund operating expenditures” and could find none.
The Staff points out that they have recommended the 25% reserve level ($9.9m) because of the potential risks from wildfire and earthquake. While these are real risks for sure, we believe a more efficient way to deal with economic loss from these natural disasters is through maintaining proper insurance and risk management programs rather than cash collateralizing for potential economic loss. Additionally, in the event that the unthinkable did occur, the Town would be able to tap Federal aid such as FEMA funding.
To test the real world impact of a wildfire, we reviewed the recent experience of the City of Santa Rosa in dealing with the economic loss from the wildfires that devastated the City.
The City of Santa Rosa has a “rainy day” fund policy which mandates maintaining a reserve equal to 15% of operating expenditures ($25.4m). As a result of the economic loss from the wildfires, the City had to tap the reserve for $9.4m in disaster related expenditures. In other words, the rainy day fund was sufficient to deal with this level of economic loss.
Based on our review, carrying an outsized cash collateralized “rainy day” fund, especially when the Town has a $51m in unfunded pension liability, is not the most efficient way to allocate the Town’s capital. We continue to recommend that the Town reduce this rainy day fund to 20% ($6.9m), which is still above the floor recommended by GFOA and use the $3m of released funds to pay down unfunded pension liabilities.
We also noted the Staff’s disclosure on page 3 of their memo that the FY 2018 surplus that has yet to be allocated has now increased to $5.3m as compared to the $3.7m that had been previously reported on A-9 of the Town Manager’s transmittal letter. To be clear, the Town Council has total authority over how this $5.3m surplus is to be allocated.
We strongly recommend that all of this surplus be allocated to pay down the Town’s unfunded pension liability. This is unquestionably the single best use of these funds.
In summary, between the excessive level of cash held in the “rainy day” funds plus the surplus from FY 2018 which has not been allocated, the General Fund currently has a total of $8.3m in cash immediately available to the Town Council for reallocation.
Capital Projects – $25.3m
Background
The Capital Projects fund is used to account for and report resources that have been restricted, assigned or committed for expenditure for capital outlay and infrastructure improvement projects. The largest sub-fund in this category is the GFAR which as of June 30, 2017 had $22.2m in cash as reported by the CFAR. None of the cash in the GFAR is legally restricted.
In addition to the cash in the GFAR, there is additional cash that is in the General Fund Capital Special Projects reserve. The Staff memo reports that there is $7.9m in cash in this reserve as of June 30, 2018. None of this cash has been allocated to an approved capital project, and that is why it remains in the General Fund.
This reserve is a “parking lot” which the Town uses to transfer funds to the GFAR when capital projects are approved. To get a better picture of the amount of cash available to the Town, you need to sum the GFAR cash and the Capital Special Projects reserve cash. Based on what the Staff is reporting, as of June 30, 2018 there is $23.8m of cash available for capital improvements.
The GFAR receives its funding from both direct revenues and transfers from the General Fund which are approved during the annual budget process. The FY 2019 Operating Budget calls for the GFAR to receive $1.5m of direct revenue (construction impact fees, developer contributions, Measure B funds) and $2.6m in funds transferred to the GFAR from the General Fund.
Analysis
Here is the status of the committed funds in the GFAR for the first year only of 5 year Capital Improvement Plan (reference B-11):
41 Carryforward projects from prior years $16.0m
New money for Carryforward projects $2.6m
13 New FY 2019 Capital Projects $1.1m
Total 54 GFAR projects approved $19.7m
To be clear, this budget is telling us that the Town plans to spend $19.7m in the coming fiscal year on a total of 54 projects.
While we understand that each project must be fully cash funded at time of authorization, the Town simply does not have the capacity to manage and complete 54 projects totaling $19.7m in one year. This is an unrealistic planning assumption.
Compare the FY 2019 plan with what actually happened in FY 2018. As reported in the Capital Improvement Program transmittal letter (reference A-9) the Town completed only 5 projects with a total capital expenditure of $544,972. That represents about 10% of the number projects and 3% of the planned capital expenditures.
While we understand other projects such as the Almond Grove street rehabilitation were in flight at the same time, our point stands. The Capital Improvement Program is unrealistic in both its timing of completion and cost estimates.
Poor planning assumptions leads to having capital allocated to projects that won’t be completed within the planned timeframe. Essentially this capital is “stranded” and therefore unproductive. The other impact is that the delay in completion causes the original cost estimates to become stale and subject to cost escalation or even worse scope creep.
You can clearly see the impact of cost escalation/scope creep on carryforward projects in the schedule above. Approximately $2.6m of the $3.7m of new capital expenditures approved for FY 2019 was allocated to carryover projects (reference B-11)! This represents a 16% increase in the prior cost estimate for the carryforward projects.
Our recommendation is for the Town Council to perform a yearly review of every capital project to make sure that the project is on track and is still consistent with the Town priorities. Capital projects that are not aligned with current priorities should be canceled and the funds returned to the General Fund. Carryforward Capital projects that need additional funding need to be justified.
Additionally the Town should only plan a number of projects that the Town can realistically supervise and manage. There is no way the Town can effectively plan, bid out and manage 54 capital projects simultaneously. This overscheduling leads to capital being “stranded” in approved but backlogged projects, which are then subject to future cost escalation or scope creep.
Based on our review of the approved GFAR projects in the current year, we would recommend that 50% of these projects be immediately canceled with the cash returned to the General Fund. This money can stay in the General Fund Capital Projects funds and be reprogrammed in following years. It simply makes no senses to have a yearly capital improvement plan that the Town cannot execute.
Internal Services Funds – $10.6m
Background
As the Staff noted, the internal services funds are used to finance and account for special activities and services performed by a designed department for other Town departments. These funds are fully reimbursed by the General Fund on a cost reimbursement basis. None of the cash in these funds are legally restricted. The use of these funds is under the full control of the Town Council through administrative actions.
Since these funds are fully reimbursed for the cost of activities and services performed, the question is how much cash should be held in the internal services funds? Is the current level excessive and how do we know that?
Analysis
Again a good metric to use to determine if cash levels are excessive is to look at the ratio of cash balance as a percentage of total operating revenues.
Using the 2017 CAFR as the reference document, at the end of FY 2017 there was $9.8m cash held in the Internal Services Funds. The total operating revenues for FY 2017 was $5.2m. Dividing the cash balance by the operating revenues, we get 189%. Compare that to our neighbors the City of Campbell (135%) and the City of Saratoga (120%). Clearly Los Gatos is holding materially more cash than neighboring cities of similar size and scale.
This means that there is there is 23 months (almost 2 years) of operating revenue held in the form of cash.
This strikes us as an unreasonable cash balance, especially since the expenses incurred by the funds are reimbursed by departments of the Town. The reimbursement process is controlled by the Staff.
The Staff included in their analysis a number of graphs which showed the change in fund balances for a number of the internal services fund from FY 2011 – FY 2017. Unfortunately these graphs does not tell the whole story regarding the changes.
Again using the FY 2011 through FY 2017 CAFRs we computed the total change in internal service funds cash balances since June 30, 2010.
The following schedule details the change.
Change in Cash Balance FY 2010 – FY 2017
June 30, 2010 Cash Balance-beginning $12,270,084
Plus:
Excess cash reimbursement over cash costs $2,393,190
Less:
Transfers of cash out $4,848,162
Capital Expenditures $ 6,083
June 30, 2017 Cash Balance-ending $9,809,029
So what does this schedule tell you?
First, over the 7 year period (FY 2011 – FY 2017) the internal services funds were OVER reimbursed by the General Fund by $2,393,190. This clearly raises the question why would this occur if the internal services funds are to operate on a cost reimbursement basis?
Secondly, it strongly suggests that the internal services funds have been historically used as a “parking lot” to hold excess cash which can then be transferred to other funds by the Staff. To be very pointed, the primary reason that the cash balance of the internal service funds (and therefore the fund balances) decreased since June 30, 2010 is due to the Staff transferring out $4,848,162 to other funds.
Our recommendation is for the Town Council to perform a detail review of the Internal Services Funds and establish more realistic cash balance targets understanding that these funds are reimbursed for 100% of costs incurred. We would recommend setting a target equal to 100% of operating revenue (i.e. 1 year of revenue held in cash) as a more prudent level. By doing this, and additional $5m of cash can be reallocated to more important areas.
Conclusion
By improving the Town’s current capital allocation process, we believe there is at least $13.3m of cash which can be immediately reallocated to higher priority needs. Two needs that are immediately top of mind are paying down the unfunded pension liability ($8.3m) and making additional investment in road repair and maintenance ($5m).
The benefits of doing this are compelling and there is simply no reason for not moving forward.
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