Strategies for Establishing Capital Asset Renewal and Replacement Reserve Policies

Type: 
Best Practice
Background: 

Governments of all sizes can benefit from capital asset renewal and replacement reserve policies as part of a government’s approach to Capital Asset Management. Well-designed capital reserve policies support proactive financial management given the many demands on a government’s resources. Reserve policies help governments prudently manage their substantial investments in capital improvements and give them a strategic tool to use in optimizing asset repair and replacement.

Fiscal constraints including financial capacity and an inability to contemplate all capital expenditures that may arise in a budget cycle, along with environmental issues and weather events, introduce uncertainty and an inability to budget and plan for every contingency. As part of the capital planning process, GFOA recommends that governments establish Capital Planning Policies that undertake a multi-year planning and budgeting process to accumulate funding for anticipated capital needs. Vigilant Multi-Year Capital Planning and careful funding decisions should be made for categories such as fleet, technology and smaller facility needs, though these may not be itemized in a CIP.

Reserves may be used to proactively manage capital assets, for instance by annually setting aside 20% of a five-year asset’s replacement costs so that funding is available when replacement is necessary. In contrast, reserves can also be available for unforeseen or catastrophic capital needs. In either case, the development and use of capital reserves should be supported by clear policies identifying how the reserve will be formed, how it may be used, and other considerations.

Capital reserves development and use should be designed to best serve the particulars of a given organization.

Recommendation: 

GFOA recommends that governments adopt a written policy addressing capital asset reserve for renewal and replacement. Though maintenance and/or renewal and replacement capital projects should be funded each year through the budgeting process, the establishment of a capital asset reserve provides governments additional flexibility in a strong capital asset management program. 

Reasons for Adopting a Capital Reserve for Renewal & Replacement Policy:

  • Shared Vision: A formally adopted policy promulgates a shared understanding of the proper level and use of reserves, facilitating healthy working relationships.
  • Objectivity: Utilizing reserve policies to manage the decision-making process provides a rational framework to guide decision-making and promotes responsible long-term planning.
  • Fiscal Justification: Public agencies face scrutiny over whether to raise taxes, rates or fees. Having a capital reserve policy in place along-side these discussions serves as a valuable tool for making and explaining difficult decisions.  
  • Credit strength:  Implementation of a capital assets reserve for renewal and replacement policy is also viewed positively by bond rating agencies as it demonstrates strong financial management.
  • Public Awareness: Adopting a Capital Reserve for Renewal and Replacement Policy can help better communicate the need for prudent planning, asset management and establishment and maintenance of reserve levels.

Steps in the establishment of a capital reserve policy:

  • Define what problem/risk needs to be mitigated or managed. Identify the goals of the entity’s capital reserve(s).
  • Define the intended use of reserve funds.  For reserves intentionally accumulated toward periodic capital expenditure, set parameters around the accumulation and use of funds.  In addition, for reserves that will be used for unforeseen events, set parameters for minimum and maximum reserve levels as well as a framework for replenishment should the reserve fall below the minimum level. 
  • Develop utilization/evaluation criteria for use of reserves based on principles such as safety and security, maintenance and utility costs,  asset readiness metrics, availability of repair parts and materials, sustainability, technological innovations, aesthetics and general appearance and other criteria identified by the organization.
  • Establish periodic, systematic review of all reserves to ensure they are serving their intended purpose. This would include assessing utilization/evaluation criteria. Benchmarking should be conducted regarding reserve levels and reserve policies using rating agency financial metrics, risk-based reserve analysis (asset management/ condition and age-based risk of failure), and by comparison to similar sized entities.
  • Ensure reserve policies coincide with all rate/user charge, debt ratio covenants, and similar requirements if a capital asset reserve is being used for enterprise/utility operations,
  • Review the legal framework to ensure compliance with state and local laws/ordinances.

Examples of annual funding allocations/levels for a capital asset reserve are as follows:

  • Maintain a minimum ending balance equal to a dollar amount or a percentage of the five-year average of the entity’s annual capital budget. (The actual dollar amount or percentage should be set based on the particular entity’s capital needs and financial capabilities.)
  • Annually contribute an amount based on a percentage of the annual depreciation of the entity’s assets. Funding sources will vary and may include transfers from the General Fund, proceeds from property sales or one-time revenues, etc.  An entity may wish to consider initial funding levels for the first one to five years with a plan for increasing funding thereafter until the target funding level is achieved. In addition, organizations should consider the pros and cons of the level of reliance on one-time versus recurring revenues based upon the financial conditions of the jurisdiction and the goals of the reserve.

Together with established capital reserves and supporting policies, jurisdictions should also develop a detailed capital asset life cycle model for all capital assets via a multi-year capital planning process.  This will help minimize reliance on reserves and move an organization toward properly budgeting its capital needs.

Approved by GFOA's Executive Board: 
March 2019