The road to fiscal sustainability: five principles of effective financial planning.

Many different organizations have promulgated best practices for the government finance profession, including the International City Managers Association (ICMA), the National Advisory Council for State and Local Budgeting (NACSLB), the Governmental Accounting Standards Board (GASB), and, of course, GFOA. Similarly, the three major credit rating agencies have published numerous articles and publications identifying the financial practices and indicators they consider important to financial examination and credit ratings for governmental securities. Despite this wealth of information, there is no single indicator of fiscal soundness or a silver bullet action to solve financial problems--it takes constant attention and a variety of policies, decisions, and actions over time to achieve fiscal stability.

This article discusses five principles that have put the City of Scottsdale on a path toward long-term fiscal sustainability. The five principles of effective financial planning are: (1) maintain a multi-year perspective, (2) fund lifecycle costs and reserves, (3) perform revenue and expense analysis, (4) document forecasting assumptions and methodologies, and (5) continually reassess plans. The balance of this article discusses each of these principles in turn.

MULTI-YEAR PERSPECTIVE

The one principle that has had the most significant impact on Scottsdale's financial success is the application of a multi-year perspective to nearly everything we do. The credit rating agencies all use multi-year financial planning as a key factor in their analysis. The NACSLB considers a long-term perspective one of the five essential features of a good budget process and recommends preparing multi-year revenue and expenditure projections; assessing long-term financial implications of current and proposed policies, programs, and assumptions; and developing plans to achieve organizational goals. A multi-year perspective is essential to understanding the full financial impacts of policy decisions and ensures a greater understanding of the issues and adequate time to plan actions accordingly. Failure to look at decisions over many years can create problems, compound problems, or delay recognition of existing problems.

A multi-year perspective can help a government avoid dangerous financial practices, including the following:

* Balancing the budget by repeatedly using one-time sources of revenue, such as prior year's reserves or proceeds from the sale of an asset

* Deferring current costs to the future, such as postponing expenditures for maintenance and replacement of capital assets, or deferring pension liabilities

* Ignoring long-range or lifecycle costs of a liability, such as a decision to build or purchase a capital asset without calculating the full lifecycle costs of owning, operating, and maintaining that asset

Most financial problems do not develop suddenly. Instead, they build over time. As such, governments need to be constantly on the lookout for signs of financial trouble. One of the best tools for assessing financial condition and identifying problems while they are still manageable is fiscal trend analysis. Fiscal trend analysis involves examining the magnitude and rate of change for a variety of key indicators of financial condition, comparing the results to other trends and benchmarks, determining which trends indicate a problem or emerging problem, identifying the possible causes, and planning remedial action.

The City of Scottsdale received the GFOA Award for Excellence for its annual Financial Trends Analysis report. The city also prepares monthly financial update reports for elected officials and management and posts these reports to the city's Web site for informational access by employees and citizens. These reports combine past and current financial trend information with an updated assessment of revenues and expenditures and many local, regional, and national economic indices. This analysis provides the earliest warning of emerging problems, provides direction for future forecasts, keeps stakeholders informed, and helps promote fiscal dialogue. Exhibit 1 is an excerpt from the May 2005 report.

LIFECYCLE COSTS AND RESERVES

The credit rating agencies consider adequate funding of lifecycle costs and reserves a critical factor in analyzing a government's financial condition and assigning a bond rating. The NACSLB recommends that governments identify and conduct an assessment of their capital assets, including the condition of the assets and factors that could affect the need for or ability to maintain the assets in the future. GASB Statement 34 represents a significant step forward in recognizing the lifecycle impacts of aging assets and infrastructure.

We've all heard the expression "Pay yourself first or pay more later." This certainly applies to this discussion, since the failure to take care of fixed expenses, protect your asset base, and plan for future contingencies or emergencies only leads to higher costs over the long run. Lifecycle analysis (also known as repair/replacement cost analysis) is imperative for effective capital project planning and sound procurement decisions. For example, the "low bid" may have much higher operating and maintenance costs, a shorter useful life, and higher replacement costs than competing alternatives, making it a less desirable option than it appears. Scottsdale recently adopted a new environmental policy that establishes the goal of achieving the Green Building Council's gold certification level for high-performance, sustainable buildings. This policy requires more planning and lifecycle costing on the front end--and perhaps a higher up-front investment--but with the desired outcome of more responsible environmental stewardship and lower costs of ownership over the long term.

As part of the city's annual fiscal reassessment and multi-year financial plan preparation, we make sure that these lifecycle costs are addressed early in the process. We also make sure that all fund reserves are fully funded before we look to fund new capital projects and/or service enhancements. Funding lifecycle, repair/replacement, and fund reserves is one of the most effective, if not the most effective, practices for guarding against deteriorating infrastructure, preventing escalating future budget costs, and ensuring that there is adequate working cash to handle revenue shortfalls or unanticipated changes in revenues or expenditures. To determine the appropriate level of fund reserves, Scottsdale uses actuarial assessments for employee benefits, risk, and insurance, and valuation consultants and lifecycle cost analysis for infrastructure and fleet needs. Exhibit 2 includes extracts from Scottsdale's financial policies that address lifecycle costs and fund reserves.

When I was hired by Scottsdale, the city had no formal reserves. Today we have financial policies that prescribe the level of reserves for every fund. Every year we review our financial policies with our elected officials, recommend changes, and re-adopt the policies (as recommended by GFOA). Our multi-year perspective and "pay yourself first" philosophy established the conditions that have allowed the city to achieve adequate fund reserves and fiscal sustainability. Over time, these lifecycle and reserve planning efforts were rewarded with bond rating upgrades, culminating in triple-A ratings by all three rating agencies.

REVENUE AND EXPENSE ANALYSIS

The NACSLB recommends that governments analyze revenues and expenses together and that they consider the implications for other financial indicators prior to making budgetary decisions. According to the NACSLB, "A large unexpected variance in a major revenue source is usually a major problem, but even a relatively small variance in a major revenue source can have a significant impact. The better the ability of a government to predict these changes, or at least their direction, the less disruptive these changes will be. In addition, improved estimation of these revenues will enhance the confidence of stakeholders in the overall revenue projection." Revenue and expense analysis is considered a "Significant Best Practice" by Fitch and a "Top Ten Management Practice" by Standard and Poor's.

Expediency, insufficient data, or lack of effort can cause governments to analyze only one side of the revenue-expense equation. Examining both sides of the equation requires a hard look at all available revenue options and a full accounting of expenses to ensure that there are no hidden surprises either now or in the future. This brings to mind another simple but powerful expression: "Live within your means." If ongoing expenses are outstripping ongoing revenues, something must be done to restore balance. Otherwise, you will face certain fiscal trouble in the long run.

The NACSLB recommends that governments periodically estimate the impacts and potential foregone revenue of policies that exempt from payment, provide discounts and credits, or otherwise favor particular categories of taxpayers or services. New revenue growth and capital project operational costs should also be factored into strategic (multi-year) financial planning to long-term financial sustainability. You may also wish to consider intangibles, such as economic multipliers and public benefits on the revenue side and indirect and lifecycle costs on the expense side. Below are some things to consider in a revenue and expense analysis.

Revenue considerations:

* Direct revenue--fees, charges, taxes, lease revenue, fines, grant or sponsorship funding

* Indirect revenue--revenue from re-spending of direct revenues by business for supplies

* Induced revenue--economic multipliers from changes in local consumption, increases in personal income, or new jobs

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