February 7, 2000

To: Policy and Finance Committee

From: Chief Financial Officer and Treasurer

Subject: Longer Term Reserve and Reserve Fund Adequacy and Funding Strategies

Purpose:

To identify longer term funding strategies for the City's reserves and reserve funds to improve the financial strength of the City.

Financial Implications and Impact Statement:

There are no immediate financial implications from this report. Further reports will identify specific funding strategies beginning in 2001 dealing with unfunded liabilities and amounts that should be set aside in reserves and reserve funds to offset future costs of various items.

Recommendations:

It is recommended that:

(1) the Chief Financial Officer and Treasurer be requested to continue to report on the adequacy of reserves and reserve funds, and identify funding strategies to enhance the City's financial position; and,

(2) the appropriate City Officials be authorized and directed to take the necessary action to give effect thereto.

Background:

The legal and administrative structure for reserves and reserve funds is the subject of a separate report to the Policy and Finance Committee by the Chief Financial Officer and Treasurer. This report presents longer-term strategies that will govern subsequent reports dealing with reserves and reserve funds.

Comments:

(A) Introduction

Reserves and reserve funds are established for a variety of purposes, each designed to ensure the ongoing financial stability of the organization:

(1) for unexpected or unpredictable events, for example, major insurance claims or extraordinary snow storms;

(2) to smooth expenditures which would otherwise cause major fluctuations in the operating or capital budgets, such as major facility maintenance; and

(3) to provide for planned future major expenditures, such as TTC vehicle replacements.

It is projected that the City will have in excess of $900 million in reserves at the end of 1999. While this amount is substantial and specific reserves are adequately funded, the majority of the City's reserves and reserve funds are underfunded in a number of areas and the overall balances are dropping. In comparison to GTA municipalities, the City's overall level of reserves is lower than they should be. In absolute terms, there are a number of reserves that are substantially underfunded and there are other situations where long term financial planning indicates the need for reserves that do not yet exist. As a result, the City's financial position needs improvement.

This report presents a preliminary summary of the adequacy of the City's reserves and reserve funds, makes a comparison with other municipalities, and highlights some initial strategies which will be further developed in the coming months to help the City move to a more secure financial position.

(B) Adequacy of Reserves and Reserve Funds

Notwithstanding what appears to be a significant level of reserve and reserve funds in general, there are reserve and reserve funds that are seriously underfunded and present a potential funding challenge to the operating budget in the future. Attachment 1 contains a preliminary review of some of the major reserves and reserve funds and the risks to the City with regard to the short and long term. At present, certain reserves are not adequately funded in the short term, including the reserve to fund vehicle replacements. Over the next five years the Operating Budget will need to absorb a potential $177 million in additional contributions to reserves and reserve funds to adequately protect the City. The potential impact on the tax rate just from the reserve contribution pressure would be a 6.8% tax rate increase across the entire tax base, or, if only the residential tax base were available, an increase of up to 18.4%.

Table 1 presents the 5 year and future year impact on Operating Budget of the projected reserve inadequacy which has been identified to date.

TABLE 1

ADEQUACY OF RESERVE AND RESERVE FUND

Table 2 is a schedule of reports on the level of adequacy of the major reserve and reserve funds which will be tabled with the Policy and Finance Committee over the course of the next several months. A series of reports on financial risk planning will also be presented that will indicate some financial impacts that result from changes in the business cycle and the weather. The series will also examine the financial impacts of social and demographic shifts, infrastructure changes and their inter-relationship with the Official Plan and the City's strategic plan.

TABLE 2

SCHEDULE OF FUTURE RESERVE AND RESERVE FUND ADEQUACY REPORTS

Work has been underway to document the level of reserve and reserve fund adequacy and to provide Council with strategies to address the underlying situations. A preliminary review of the adequacy of the City's reserve and reserve funds already reported to Council has revealed that several are significantly under-funded with respect to meeting the obligations for which funds were set aside.

The vehicle and equipment replacement reserve is currently under severe pressure as indicated in the report (July 13, 1999) entitled "Corporate Fleet Vehicle and Equipment Replacement Reserve" and is under-funded by an estimated $200 million. Finance, in conjunction with Fleet Management Services, is exploring leasing as a partial solution to the problem.

A report to Council on the Social Assistance Stabilization Reserve in November, 1999 showed that the reserve, which currently has a balance of $16 million, could have future requirements as high as $326 million over a period of 4-6 years. Actual requirements will depend upon the depth and duration of the next economic downturn. A recommendation has been made that consideration be given to increase the 2001 Operating Budget by up to $5 million to finance future case load increases, along with provisions from underexpenditures resulting from caseload reductions.

(C) Comparative Levels of Reserves and Reserve Funds

A comparison of the City's reserves and reserve fund balances has been made with 64 Ontario municipalities using two indicators - reserves per capital and debt/reserves ratio:

(1) Reserves per capita - this is a common measure used by the credit rating agencies to compare levels of reserves. In 1997, Toronto ranked 44 out of 64 municipalities, making it clearly the worst in the Greater Toronto Area. In fact Toronto was 36% below Pickering, the second worst in line.

The City had reserve levels of less than one-third that of Mississauga on a comparative basis and ranked lower than municipalities such as Hamilton, Kitchener, Richmond Hill and Thunder Bay.

In comparison with other regions in Ontario adjusted for equivalency based on converting two tiered systems to one tier, Toronto still fares poorly with respect to GTA regions and the Provincial average but is better off than Niagara or Sudbury based on 1998 figures.

(2) Debt/Reserves - A loose benchmark used by the credit rating agencies for a municipal credit rating of AA (or better) is a Debt/Reserve ratio of 1 or lower, meaning having liquid reserve in excess of net debt outstanding. At the end of 1998, the City's ratio was only slightly below that, at 1:1.1 (without the TTC reserves) and 1:0.8 (with the TTC). On a comparative basis, the City ranked 22^nd out of 64 municipalities in the GTA in 1997. This confirms the fact Toronto has lower reserve / higher debt than almost all of the GTA municipalities, and is in a less favourable financial position than most other GTA counterparts.

Because the reserves in 1999 are projected to deteriorate slightly from those in 1997 and the debt is forecasted to rise dramatically over the next several years, the trend in the ratio is upward. As presented to the Budget Advisory Committee and the Policy and Finance Committee, current projections based on the preliminary 2000-2004 capital program indicate that the City's net debt will rise from $1.1 billion at the beginning of 1999 to over $2.3 billion by the end of 2004. Were that to happen and reserves maintained at existing levels, the debt/reserve ratio would degrade to 2.7:1 and place Toronto in sixth last place. The credit rating agencies have already taken note of this trend and, left unchecked, this situation could further damage the City's financial position and, ultimately, its credit rating.

(D) Trends in Toronto's Reserves

During the years 1998 and the early part of 1999, Council took various actions to either establish additional reserve/ reserve funds or transfer budget underexpenditures into those funds. The total Reserves and Reserve Fund balance as at December 31, 1998 was $966 million, which is a slight improvement from the previous year ($929 million as at December 31, 1997). The increase in fund balance can be partly attributed to the $16.2 million paid into the Social Assistance Stabilization Reserve Fund in 1998 and partly due to a contribution to the snow clearing reserve.

The total reserves and reserve funds balance for 1999 year-end is projected to be approximately $928 million, representing a decrease of 12% from 1998 (excluding the one-time TTC reserve funds from an amount of $830 million that the Province provided in 1998 as a "balloon" payment to discharge its future long-term obligation for transit capital such as the Sheppard Subway). Part of this drawdown is due to predictable withdrawals of funds for 1999 snow clearing costs and debt charges for the Sheppard Subway, while part is due to insufficient provisions for items such as vehicles.

The reduction is primarily due to the decrease in the Vehicle and Equipment Replacement Reserve ($21 million) and the Water accounts ($97 million), offset partially by an increase in the Employee Benefit accounts ($20 million).

(E) Strategy for Addressing Funding Shortfalls in City's Reserves:

If the City is to address its reserve funding inadequacies and move to placing the organization on a sustainable financial footing for the future, difficult decisions will have to be made which in most cases will place added pressures on the operating budget. There are essentially three areas that must be dealt with in time and will be addressed on the basis of the following priorities:

(1) Immediate pressures - Some reserves and reserve funds that are currently unfunded will present very short-term pressures for the operating budget. One example is the reserve for vehicle replacements which, with current levels of funding, will be exhausted at the end of 2001. The annual operating budget impact which must be incorporated over the next several years is in excess of $20 million. An example would be the insurance reserve, currently underfunded by about $3 million annually.

These types of reserves are being addressed in an urgent manner and individual reports presented to identify the best strategies for placing them on a sustainable basis and for phasing in the appropriate level of funding. Phase-in time frame: 1-5 years.

(2) Medium Term Pressures - These include existing reserves that are underfunded and which present medium-term financial difficulties for the City. As an example, funding for the Social Assistance Reserve will require $5 million additional operating budget contributions over the next 3 years, combined with provision of underexpenditures from in-year reductions in welfare caseloads. Similarly, a recently updated actuarial study has shown that employee benefit reserves are underfunded by between $195 million and $705 million. The lower figure represents the five year requirements that are reported on the City's financial statements and the higher figure is the total unfunded liability. Phase-in time frame: 2-10 years.

(2) Longer Term Pressures - This reflects the need to create new reserves as part of a strategy to support longer term financial strategies. Some examples include infrastructure repair and maintenance reserves for items such as facilities, transportation and major vehicle purchases. The recommended phase-in strategy will be to establish reserve contributions initially for all new construction and, over a longer time frame, phase in full funding for all existing infrastructure as well. Phase-in time frame: new infrastructure: 1-3 years; Existing Infrastructure, 20-30 years. These concepts are explored below.

(i) Longer Term Reserve Strategy for Infrastructure Replacement and Maintenance

Over the years, the former municipalities that comprise the new City did not make adequate financial provisions for the deterioration associated with the City's infrastructure - buildings, roads/sidewalks/bridges, water and sewer piping and facilities, and major software upgrades including networks and data warehousing. Ideally, the annual deterioration (depreciation) of these assets caused by the delivery of the service should have been provided for through contributions from the operating budget to support a reserve fund so that when an element of the infrastructure required major maintenance or replacement, funds would have already been set aside for this purpose. The operation of the vehicle and equipment replacement reserve, which some municipalities maintained, illustrates the point. As each vehicle was purchased, the cost was pro-rated over the useful life of the vehicle and set aside in a reserve so that when the vehicle was retired, funds were available in the reserve to replace it with no additional burden on the tax rate. The current funding problem has arisen because not all vehicles were funded in this manner.

A similar concept is embedded in condominium legislation, whereby the condominium corporation must set aside, on an annual basis, sufficient funds in a reserve to address future major maintenance requirements. In this case, technical audits of the buildings are done periodically to determine how much useful life remains in a variety of building elements. These elements are costed and a schedule of annual payments is determined so that adequate funds are available, as each element is required to undergo major renovation or replacement. In this way there are not major swings in maintenance fees to owners.

Similarly, the City ought to be creating reserves for all infrastructure. Funding for such reserves would have to be provided from the operating budget. The capital budget analysis indicated that the insured value of the City's infrastructure was $22 billion. A depreciation number normally used for buildings is 2.5% - which if applied to the whole portfolio would be $550 million. In the current environment setting aside funds in a contribution to reserve or to capital from current of this magnitude would be totally unaffordable.

Following is an illustration of a reserve funding strategy that should be applied to major asset repair and maintenance:

Because of affordability constraints, it is recommended that initial funding for this type of strategy be applied to new facilities only and be directly tied with the capital approval process. This will still mean a significant pressure on the operating budget for each of these new facilities since there will be three sets of costs initially - debenturing, maintenance reserve contribution and staffing and other operating costs.

In conjunction with the 2001 capital and operating budget, it is recommended that annual reserve contributions of 2.5 per cent. of the value of each new facility should be established immediately upon financing approval. This amount is based on industry standards for the long-term costs of items such as roof replacements, and HVAC upgrades/replacements. Like the vehicle replacement program, the reserve contribution will be determined and tracked separately for each facility. Eventually, existing facilities should also incur a charge.

For existing infrastructure, programs will be proceeding to establish the base requirements through technical audits and life cycle analyses, determining the appropriate contribution rate to the reserves for incorporation into subsequent operating budgets. Funding strategies will be prepared with a longer phase-in and recommendations made for Council's approval.

(ii) Reserves for TTC Replacement Vehicles

Funding of TTC replacement vehicles will place extraordinary pressures on the City over the foreseeable future, largely as a result of the elimination of all Provincial subsidies. Efforts are underway to secure ongoing funding sources from senior levels of government, but it is the magnitude of the expenditures and the extremely variable nature of the vehicle purchases that will most impact the City. It is important to develop an overall funding strategy that would be required regardless of whether partial funding is secured from other levels of government.

By way of illustration, the following graph demonstrates the variability from one year to another on the total cost of replacing TTC vehicles, including subway cars, streetcars and buses:

Using traditional debenture financing, this expenditure pattern would translate into severe operating impacts in those years where the expenditures peaked:

A preferable approach would be to establish a longer term financing plan that would provide at least part of the future purchase requirements in a reserve, with the ultimate goal of providing sufficient annual funds in the operating budget to fund the average annual consumption of vehicles. This is very similar to the vehicle and equipment replacement funding used for the City's fleet except that the asset has a much longer life and the withdrawal pattern is much more extreme. By definition, this means that the financial impact occurs sooner, but would allow the City to phase in the full funding over time and avoid the severe operating impacts that are inevitable in future operating budgets.

The following graph illustrates a possible phase in using a combination of debt and reserves until the reserves are established at a level sufficient to fund future purchases:

Conclusions:

In absolute terms, the City has a substantial level of reserves, projected at the end of 1999 in excess of $900 million, excluding one-time accounts holding the remnants of TTC provincial capital subsidies. Some reserves have adequate funding for future commitments. However, from a comparative standpoint, the overall level of reserves does not match that of many other municipalities and, along with trends in the City's debt levels, was cited by the Canadian Bond Rating Service as one of the contributing factors in the recent downgrade in the City's credit rating. Further, specific reserves are underfunded and it will take a concerted effort over many years for the City to properly fund its reserves and to move to a more appropriate longer term financing of its infrastructure maintenance program.

Adequate funding of infrastructure repair, maintenance and, in some cases, replacement cannot be deferred indefinitely. Council will have to make difficult trade-offs in its funding decisions and the use of reserves will continue to be an appropriate mechanism for funding future expenditures in a planned, rational fashion. This report recommends that the City continue to address the funding shortfalls, including the initiation of annual provisions to building maintenance reserve funds starting in 2001 for all new facilities.

Detailed reviews of reserves will be completed in the next several months, leading to a more detailed funding strategy that will be placed before Council.

Contacts:

N. Donald E. Altman, Manager, Financial Planning, (416) 397-4220; Fax (416) 397-4555; E-mail: daltman@mta1.metrodesk.metrotor.on.ca

Len Brittain, Director, Treasury and Financial Services, (416) 392-5380; Fax (416) 397-4555; E-mail lbrittai@toronto.ca

Chief Financial Officer and Treasurer

List of Attachments:

1. Preliminary Adequacy Assessment of City's Major Reserves and Reserve Funds

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Attachment 1

Preliminary Review of Adequacy of Major Reserves and Reserve Funds