A few words about the budget

The Merry-Go-Round is willing to wager that Council will not tarry long before approving the two-year General Fund budget to be presented Tuesday.

And why should it?

Those on the dais will be told that the budget projects a $1.2 million surplus in Fiscal Year 2015-16 and break-even in FY 2016‑17.  What’s more, according to the staff transmittal letter, “This is the first budget in the last three years where departments were not required to cut their budgets.”

Elena Adair

Elena Adair

Liz Warmerdam

Liz Warmerdam

Well, we don’t want to rain on the parade as Interim City Manager Liz Warmerdam and Finance Director Elena Adair march in with the first budget for which they are jointly responsible.  (And that will be us beating the drums of praise for Ms. Warmerdam for putting together the budget workshops at which department heads defended their budgets as if they were graduate students facing an orals board).  But for those happy few who care about such matters, a few words of qualification are in order.

Take the way in which staff has made the numbers add up for the next two years.

Yes, the FY 2015‑16 budget projects a surplus, but the staff report discloses that revenues for the year include a $2.2 million “loan repayment” from Alameda Municipal Power.  Without this repayment, the $1.2 million surplus turns into a $1 million deficit.

Relying on AMP to supply funds to pay for the City’s operating expenses is a familiar technique.  AMP made a $1 million “advance” of its Payment In Lieu Of Taxes to the City in FY 2012‑13 and a $1.2 million PILOT “advance” in FY 2013‑14, both of which were counted as General Fund “revenue.”

And the “loan”?  According to the City’s CAFR, back in 2003 Council authorized an interest-free loan of $2,200,000 to AMP “for the purpose of construction of the hybrid fiber-optic/coaxial telecom system.”  The debt was due on June 1, 2009, but it was not repaid.  Instead, the City has been carrying it as an asset on the General Fund balance sheet – until now, when, for unexplained reasons, AMP has decided to cough up the cash.

We can only wonder how long staff and Council can count on AMP to supplement the taxes the City collects from its residents.  Oh, did we mention that, by Charter, the City Manager sits on the board of the Public Utilities Board that oversees AMP?

And, yes, the “annual operating results” for FY 2016‑17 are projected to be break-even, but the staff report states that, “Staff is proposing to balance the projected deficit totaling $1.229 million in the General Fund for FY 2016‑17 through the carryover of budget savings in the General Fund projected for FY 2014‑15 and 2015‑16.”  To put it another way, the budget actually forecasts a $1.2 million operating deficit – expenses ($83.3 million) will exceed revenues ($82.1 million) by that amount – and the City is dipping into General Fund reserves to cover the shortfall.

This, too, is a standard ploy.  Beginning with the FY 2012‑13 budget, staff began referring to the practice of using reserves to make up operating deficits as a “carryover” of “budget savings.”  Under staff’s theory, if the City earns a profit – or even if it simply does better than originally predicted – in one fiscal year, it can “carry over” the “savings” to the next fiscal year.  So, this time, the profit earned in FY 2014‑15 and projected for FY 2015‑16 will be “carried over” to cover the deficit in FY 2016‑17.

But let’s be clear.  Whatever clever label is slapped on the maneuver, what’s happening is that the City is drawing down General Fund reserves to pay for current operating expenses.  It’s no different than using your savings account to pay the bills your salary won’t take care of.  At some point, the “carryovers” will have to stop – because all of the reserves will have been “carried away” to cover the annual deficits.

These time-tested – and, we hasten to add, perfectly legal – methods for producing a rosy budget picture drew no criticism from former Mayor Marie Gilmore and her colleagues on the former Council, who were only too happy to pretend that the budget was “balanced” every year.  This year, it will be interesting to see whether Vice Mayor Frank Matarrese speaks up.

During the campaign, Mr. Matarrese inveighed against the use of “one-time” funds to pay for operating costs, and after he took office, he submitted a Council referral setting forth a set of “principles” to guide staff in preparing the budget.  One was that “one-time revenues” shall “not be included as General Fund revenue or applied to General Fund expenses.”  The budget to be presented Tuesday directly violates this guideline.

As has become his habit, Mr. Matarrese backed away from his position once the issue came up for Council discussion.  He didn’t really mean “principles,” the Vice Mayor said.  “Talking points” was more like it.  Thus . . . clarified, the referral passed, 4‑1.  So it remains to be seen whether Mr. Matarrese will make a point Tuesday of talking about his one-time advocacy for a ban on the use of one-time funds.

These comments about the two-year budget may seem niggling in light of the bigger picture.  As Council and staff repeatedly reminded us during the budget workshops, the City is predicted to have $29.6 million in General Fund reserves at the end of FY 2014‑15.  This represents a $14.5 million increase in a mere five years.

This achievement has led to a wave of self-congratulation.  As the April 16 staff report crowed, the increase in reserves is “the beneficial result of previous cuts made to get expenditures under control, and also a sign of the improving economy.”  Well, we can excuse a little bragging.  But it gets dangerous if the politicians conclude that the increase signals that the City now has finally turned the corner toward sustained profitability.

That would be misreading the evidence.  To see why, we’ve got to take a closer look at the reasons why reserves have gone up.

First, a word about terminology.  What is popularly called the “reserves” is known in accounting lingo as the “unassigned” balance in the General Fund.  Funds in this category have not been “restricted, committed, or assigned” for any specific purpose.  As such, they can be spent however Council sees fit.

The “unassigned” balance can grow if previously restricted, committed or assigned funds are made available for unlimited use.  And, in fact, that has happened several times in the last five years.  For example, donated funds “assigned” to the Animal Shelter ($231,899) and the Mastick Senior Center ($259,226) were moved to the “unassigned” category in FY 2011‑12 and FY 2012‑13.

The “unassigned” balance also can grow if money is transferred into the General Fund from another account and no limitation is placed on its use.  Sometimes, these transfers are treated as “revenue.” (This is how the AMP advances were, and the AMP repayment will be, accounted for).  Other times, they simply augment the existing “unassigned” balance.  For example, from FY 2010‑11 through FY 2012‑13, $480,000 per year from the Fleet Industrial Supply Center Lease Special Revenue Fund was transferred into the General Fund and categorized as “unassigned.”

By these means – which have no connection to actual operating results – staff’s financial wizards have managed to increase the “unassigned” balance by about $2.3 million since FY 2010-11 ($4.5 million if you count the AMP advances).  But it should be borne in mind that these internal and external transfers do not represent recurring events.  If Council decides to spend the additional “reserves” that have been created in this way, they’re gone forever.

Finally, and most commonly, the “unassigned” balance can grow if the City earns an operating profit in a given fiscal year.  In such a case, the surplus goes straight into the “unassigned” category.  (Again, it’s like putting any cash left over from paying your bills into a savings account).

This was the primary way in which the City increased its reserves over the last five years.  The annual budget summaries show that the City made a total of $11.5 million in operating profits over that period.  So isn’t this proof that the City is now running on an even keel?

Not really.  Of the $11.5 million in total operating profits, fully $7.5 million is attributable to one year: FY 2013‑14.  This result was unanticipated.  When the two-year budget was adopted in June 2013, FY 2013‑14 was expected to show a $645,000 loss.  A year later, former Finance Director Fred Marsh revised the forecast to a $2.4 million gain.  But even that revised forecast turned out to be too low by a factor of three.

What happened?  The staff report announcing the unexpected profit didn’t attribute it to superior management.  Instead, the report stated that the “majority” of the profit “comes from one time sources of revenue such as unanticipated Redevelopment pass through payments, transfer tax on the sale of two large apartment complexes, and salary savings in both the Police Department and General Government categories (City Council, City Manager, City Attorney, Finance and Human Resources).”

We’ve put the phrase “one time” in italics deliberately:  As with the internal and external transfers to the “unassigned” balance, the events generating the profits are not necessarily going to recur and, sometimes, are planned not to recur.  Take the police department salary savings.  These savings resulted from vacant positions that Police Chief Paul Rolleri has every intention of filling as soon as he can.

(In case you’re wondering what the former Council decided to do with the unanticipated profit, you can guess the answer:  Spend it.  At their last meeting before leaving office, the outgoing Council voted to spend an additional $4,512,767 in FY 2014‑15 and use the unexpected profit earned in FY 2013‑14 to cover the costs.  The second biggest recipient of the largesse was the Equipment & Vehicle Replacement Fund – you know, the source of the money for buying or leasing new fire engines, trucks, and ambulances).

The FY 2013‑14 experience demonstrates a larger truth:  The major reason for the operating profits that swelled the reserves is a factor beyond staff’s (or Council’s) control.  Ms. Warmerdam got it right when she said the increase in reserves is a “sign of the improving economy.”  Of all of the General Fund revenue items, the one that is most sensitive to economic conditions is sales taxes.  (When people have more to spend, they spend more).  It is no accident that sales tax revenue essentially doubled between FY 2010‑11 and FY 2014‑15.

This is not to say that the Russo/Gilmore administration deserves no credit for the positive operating results.  True, the actual “cuts made to get expenditures under control” occurred during the regime of former Interim City Manager Ann Marie Gallant and former Mayor Beverly Johnson.  But their successors held the line on expenses until FY 2014‑15.  In fact, General Fund expenses were the same – $71.6 million – in FY 2013‑14 as they were in FY 2010‑11.  It was only when the unanticipated profit occurred in FY 2013‑14 that staff and the former Council gave in to the temptation to loosen the reins.  As a result, FY 2014‑15 expenses will shoot up to $79.9 million.

It is surely reasonable for Council and staff to be pleased that the next budget cycle will begin with $29.6 million in reserves.  But we hope they don’t leap to the wrong conclusion. A close look at how the “unassigned” balance came to reach such a level demonstrates that it isn’t a license to embark upon a spending spree.

But enough about the past.  Let’s talk about the future.

As is customary, the staff report not only includes a two-year budget but also presents a five-year forecast.  This forecast shows that, after FY 2016-17, the General Fund begins to run annual operating deficits, and the losses total $12.5 million over three years.  Here’s the table prepared by staff:

5-year projections

Council does not have to approve the forecasts, and the politicians may be tempted to ignore them altogether.  After all, they’ve got that $29.6 million “reserve” to fall back on.  Alternatively, the current Council members could mimic their predecessors, who were wont to dismiss every budget forecast made by staff as unduly pessimistic after the actual operating results turned out to be better than Mr. Marsh had predicted in March 2011.  (“The lights are still on,” Councilwoman Lena Tam repeatedly reminded anyone who expressed concern about projected future deficits).

But there is one point they shouldn’t disregard.

A few weeks ago, when departing City Manager John Russo rushed the new public safety union contracts through Council before he left for Riverside, City Treasurer Kevin Kennedy made what struck us as a common-sense comment.  (Mr. Kennedy is known for that).  Having reviewed the MOUs in light of staff’s budget projections, the Treasurer noted that the firefighters’ and cops’ salaries and benefits would go up at a greater rate than General Fund revenues were expected to increase.  “It doesn’t make sense to have your costs going up a lot faster than your revenue,” Mr. Kennedy said.  “That’s kind of how we got into this situation in the first place.”

As it turns out, what Mr. Kennedy said about the raises is equally true for the General Fund as a whole.  According to the forecast, General Fund revenue is expected to increase by 4.66% between FY 2015‑16 and FY 2019‑20.  During the same period,  total expenditures and transfers are predicted to rise by 12.8%. (Not surprisingly, public safety costs will shoot up even more dramatically: 21.25% between FY 2015-16 and FY 2019-20).

Here’s what the data looks like:

GF Chart for blog

You don’t have to be a Certified Financial Planner like Mr. Kennedy to recognize that, if expenses go up faster than revenues, the City is going to start losing a lot of money – and soon.  And that’s exactly what the five-year forecast shows will happen.

This disparity in growth rates between revenues and expenses is an issue that Council ought to address when it considers the two-year budget.  As a practical matter, the expenses that the budget authorizes for FY 2015‑16 and FY 2016‑17 will set the floor for future budget requests.  If Council approves spending $83.3 million in FY 2016‑17 – as it is being asked to do – it isn’t going to be easy to cut back on expenses in the three years after that.

Of course, the future will be somebody else’s problem, won’t it?  Yeah, it will be:  Ours.


General Fund budget summaries: FY 2011-12 GF Budget SummaryFY 2012-13 Financial SummaryFY 2013-14 GF Budget SummaryFY 2013-14 GF Budget Summary updateFY 2015-16 GF Budget Summary

Five-year projections: June 2, 2015 GF Five-Year Projections

Staff reports: 2014-11-18 staff report re 4Q financial report2014-12-02 staff report re amending 2014-15 budget2015-04-16 staff report2015-06-02 staff report

Transmittal letter: 2015-06-02 Ex. 1 to staff report – FY 2015-16 and 2016-17 Budget Transmittal letter

About Robert Sullwold

Partner, Sullwold & Hughes Specializes in investment litigation
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