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Rainy-Day Reserves

March/April 2020

By Karla Hignite

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Developing—and communicating—a financial reserves policy can help institutions pursue and maintain a strong growth position while guarding against unexpected circumstances.

THE NEED FOR A FINANCIAL RESERVES POLICY

Idea in Brief


Institutions’ reserves are a hot topic these days—and not always in a good way. For public institutions in particular, news stories sounding an alarm of a university “hoarding” funds while raising tuition are often the result of a misunderstanding or a miscommunication about the need to set aside funds to meet planned objectives or deal with short- or long-term disruptions, such as natural disasters, unanticipated enrollment declines, or a state budget crisis.

In public higher education, institutional leaders must ensure that state legislators, and other diverse constituencies, understand what constitute reserves and why they are so vital to operational viability. Some legislators have questioned whether appropriations should decrease when institutions have large cash balances.

Simply put, reserves essentially denote liquid assets that can be used for planned enhancements, new opportunities, or the unforeseen. Consequently, a lack of understanding around the meaning of large balances—and the nature of restrictions, designations, and liquidity—raises questions from many stakeholders. Pushback may come from faculty members who question cash and investment balances when new programs are needed, or it may come from union employees who question why reserves can’t be used in the collective bargaining process to boost compensation. Even board members might be at odds with one another about what constitute reserves and their appropriate level and use.

The potential for false impressions is all the more reason to give careful thought not only to establishing a reserves policy but also to communicating cash needs and policy details to a broad base of stakeholders. Communicating with your state’s officials, for instance, can help them understand and support your goal of increasing resilience during a downturn.

One good practice is to make a list of all institution stakeholders and identify what each group needs to know and cares most about so that you can tailor your communication to resonate with each constituency. Bottom line, proactive communication about reserves and their purpose can demonstrate a well-run organization, as well as make the case for why you may even need to increase your financial cushion for inevitable bumps ahead.

The Case for Cash on Hand

California is among a number of states in recent years providing pushback related to the reserves practices of its public higher education institutions.

In the case of the California State University System, comprising 23 campuses, a letter from a union employee to the state legislature in 2018 that questioned the system’s cash balances sparked an inquiry from the state. “In fact, this has been a cyclical issue that tends to coincide with our collective bargaining activity,” says Brad Wells, the system’s associate vice chancellor, business and finance.

In this instance, the state voiced two concerns. First, CSU had not identified a minimum level of reserves. Second, the system didn’t provide adequate explanation about the nature of its cash balances when requesting additional funding from the state.

Set a target range. CSU’s primary concern with establishing a baseline reserves level was that the moment the system has to dip into reserves beyond its minimum, it would essentially be violating its own policy, explains Wells. That said, CSU set a target of at least three months of cash on hand for addressing any recessionary cycles or disaster-related events, such as a wildfire, that might shutter a campus for an unspecified time.

“In the past, one of our greatest risks was a late state budget,” says Wells. During the Great Recession, there were multiple occasions when the state delivered its budget months late. Because CSU’s payroll tops $630 million per month, leaders had to consider how much the system would need to get through a full semester, keeping everyone paid and ensuring that students could continue their coursework and graduate. To cover those commitments, the system set a target range of three to six months of operating reserves. “Institutions might establish a policy based on a variety of factors, but we tried to take a very pragmatic approach,” says Wells.

Factor in flexibility. A month after starting his role as chief financial officer for the University of Tennessee System in January 2017, David Miller was called to testify before the state legislature regarding UT’s budget. That experience clarified for him the importance of finding a better way to explain university balances.

“The good news is that the state wants us to have healthy fund balances,” says Miller. For Tennessee legislators, healthy reserves in part serve as a hedge against the university having to make substantial cuts or significantly increase tuition in the next economic downturn, he says. “For our part, we needed to develop better documentation to explain our reserves fund balances.”

Despite ample work since then to clarify reserves funds and cash flows, the university isn’t rushing to formalize a reserves policy, says Miller. The state does not require nor has it requested a policy, and Miller isn’t convinced the system must adopt one. “Our four campuses are at different levels of capacity, so we are conscious about requiring a specific fund balance that would penalize any one campus.”

Despite the lack of a formal policy, UT is establishing parameters. Each campus now understands the framework and is working toward a target goal of at least three or four months of reserves cushion, regardless of the approach each one takes to get there, says Miller.

Ratio Rationale

Complicating reserves calculations and messaging for many public institutions has been the requirements of GASB 68 (involving pension benefits) and GASB 75 (involving OPEB, short for other postemployment benefit plans). Many public institutions discuss in their MD&A the impact these standards have on net position and key ratios. The objective is to help stakeholders understand that pension and OPEB obligations will not have an immediate impact on financial resources. Since pension and OPEB accounting standards can take a toll on net position, many public institutions find it easier to use available cash to explain reserves.

Houston Community College, Texas, changed its reserves policy in 2018 from maintaining a 9 to 11 percent range of general revenues—or about two months of operating revenues—to 180 days of cash on hand, plus or minus 5 percent, according to Carin Hutchins, HCC’s associate vice chancellor for finance and accounting.

Prior to GASB liabilities—specifically GASB 68 and 75 related to pension and OPEB—net position and cash on hand were more comparable, says Hutchins. “Especially once we saw GASB 75 coming down the pike, we calculated that would add about a $116 million liability to our books. We would have been out of compliance the very minute it was implemented,” says Hutchins. “In working with our board, we recognized that days of cash on hand would be a better measure for capturing our reserves target—and a lot easier for stakeholders to understand.”

Find the happy medium. That’s not to say there has been a unanimous embrace of the new measure, says Hutchins. Because HCC has taxing authority, there is an added layer of stewardship burden on trustees, who must be sensitive to collecting more than needed from taxpayers and students. Some board members were concerned about setting such a high reserves balance, notes Hutchins. Others were convinced of the importance of building reserves to counterbalance uncertainties about state funding, ongoing deferred maintenance needs, and other as-yet unknown future liabilities—possibly including damages and operating losses from the next Gulf Coast storm, says Hutchins.

In working with a public financial management team to draft a reserves policy for HCC that calls for a cushion of six months of unrestricted cash on hand, financial advisers suggested considering a twofold policy to assess reserves from multiple measures, including days of cash on hand and net position—even if negative—to suggest a path for improvement. According to Janet Wormack, HCC’s vice chancellor for administration and finance, using the composite financial index in evaluating the college’s reserves has also been helpful, in part because the state uses the CFI to benchmark all 50 community colleges in Texas.

Not All Reserves Are Equal

The University of Tennessee System assesses reserves based on both net position and a combination of short-term investments and cash on hand. “We assess net position collectively, and then for each individual institution we have 10 carry-forward cash funds, six of which are embedded in our annual operating budget,” says Miller. Four other funds, which always appear in university financial statements, show up as unrestricted assets. “Here is where there has been confusion in the past,” notes Miller.

This bucket of renewal and replacement funds was started decades ago as a fund of state dollars and tuition to carry forward for equipment, facilities, and so forth. “Over the decades it had grown quite large because it served as a holding fund for a wide variety of future needs to be funded by that pool of unrestricted assets,” says Miller.

While still a work in progress, these renewal and replacement funds have now been grouped into four categories to better convey their purpose and reflect their commitments:

Bring clarity to reduce uncertainty. Similarly, the CSU System’s need to clarify its cash balances and reserves stemmed in part from the fact that some committed funds were being called “reserves.” As one example, the CSU System has accumulated a balance of approximately $700 million for capital projects not yet approved or financed. Because the system requires individual campuses to fund 10 percent of a project to make use of systemwide funds, a campus might spend significant time accumulating for a project. “Once approved, we move the money,” says Wells. Until that time, however, it looks like a large pot of untapped resources.

To clear up the confusion surrounding committed balances, CSU created three categories for designated cash balances: one for short-term requirements such as financial aid not yet disbursed; a second for capital projects; and a third for catastrophic events, such as earthquakes and floods, says Wells. “We then flagged our undesignated economic uncertainty funds as our true reserves and provided additional background in our policy about why we can’t use these for ongoing or recurring expenditures.”

Communication Gap

“One potential area of confusion is assuming stakeholders want to understand your financial statement,” says Wells. “We have tried in the past to delineate between restricted and undesignated and nonrestricted funds, but in truth, no one without an accounting background understands the nuance or rationale behind those designations.” At the end of the day, a financial statement is not intended as a communication tool for most stakeholders. A better approach is to think about your target audiences and what they want and need to know, which will vary by group.

For instance, the state wasn’t concerned by CSU’s target range for reserves. What it wanted was a clear connection between the system’s reserves and its budget requests, says Wells. That the state and other stakeholders weren’t clear on the basic details of CSU’s reserves policy might suggest a financial transparency problem. “In reality, it was more a failure to communicate.” In addition to determining what to communicate, the system had to determine how to better communicate about its reserves, says Wells.

Err on the side of ample communication. CSU has added more robust reporting to its financial transparency site, which it created with the group OpenGov. “We use their platform to provide a broad description of and details about our cash balances and reserves across the past five years,” says Wells.

Even though system staff members don’t use this website, the fact that CSU’s information is now widely available does seem to matter to state legislators, public policy groups, and other external stakeholders. The system also created a one-page summary within its budget showing how it would accommodate a shortfall in the event of a recession. “This is now included in our annual budget request to the state,” says Wells.

Additionally, the CSU System reports its cash balances and reserves in multiple formats. “We report cash on hand in our financial statement, designating reserves in a note. We also report quarterly on investment returns, and that reporting includes a cash balances statement,” says Wells. “More broadly, in our communication efforts, we often talk about our total resources and what they are for, and this has immensely helped our relationships with our board, legislature, governor, and students.”

Start by Taking Stock

Be intentional. For institutions that don’t yet have a reserves policy, Hutchins recommends bringing the item forward to your board. “Start simple. Assess where you are, and if you determine a need to increase your rainy-day fund, develop a plan to start bringing target goals into your budget cycle.” At HCC, key areas such as IT and facilities are now budgeting for planned, multiyear repairs and replacements. “Especially as you are looking to grow, you must be intentional with your budgeting and plan for sustainability,” says Hutchins.

Budget your cash balances. Even for money that you do not plan to expense in the current year, it’s a good idea to budget those funds. Explain amounts that will be used and those that need to be set aside, says Miller. “While there is a tendency for the public and even some board members to refer to all unrestricted assets as reserves, it behooves leaders to make clear what constitutes your actual rainy-day fund—those amounts you do not plan to spend forward unless you have to for an emergency.”

Identify strategic spending. Miller provides another bit of wisdom: Balance rainy-day and cash-on-hand needs as you assess your strategic spending priorities. “Through this process it became clear that we should consider opportunities for additional strategic spending,” says Miller. “Especially as our enrollments grow, we must put our capital to work to enhance programming and services for students.”

To that end, university leadership is looking to identify spending priorities at each individual institution and at the system administration level, says Miller. “As one example, institutions moved 22 physical plant projects through the pipeline at a recent board meeting. Likewise, system administration carry-forward balances will be used to pay for our new enterprise resource planning system without a charge back to campuses.” This was the first time the university specifically flagged a technology project for reserves spending, and after presenting the option and cost estimates to the UT board, members were convinced of the need to move forward, says Miller.

Regardless of whether or not a policy is formalized, one unsung benefit of conducting a thorough reserves assessment is the ability to identify where an institution should be spending more now—or where it may need to build a stronger base of reserves funds for future mission priorities.

KARLA HIGNITE, Fort Walton Beach, Fla., is a contributing editor for Business Officer.

SUE MENDITTO, senior director, accounting policy, NACUBO, contributed to the article.


Related Topics

The University of Tennessee System assesses reserves based on both net position and a combination of short-term investments and cash on hand.

That the state and other stakeholders weren’t clear on the basic details of California State University’s reserves policy might suggest a financial transparency problem.