Pew: States Should Establish Clear Withdrawal Rules for Rainy Day Funds

Washington—Many states struggle with when and how to make withdrawals from their rainy day funds, a situation that can lead to poorly timed use of these reserve accounts, according to a new report released today by The Pew Charitable Trusts. When to Use State Rainy Day Funds: Withdrawal policies to mitigate volatility and promote structurally balanced budgets examines these accounts and offers recommendations on how states can best determine the appropriate times to draw down these savings. The research found that:

• Six states have no legal conditions for when funds should be withdrawn. 
• Ten states have unclear conditions for when they can make withdrawals.
• Twenty-nine states do not include revenue or economic fluctuations as criteria for determining when withdrawals from these funds are appropriate.

“A well-designed rainy day fund can give a state the flexibility it needs to weather the revenue impact of economic downturns,” said Robert Zahradnik, director of state budget policy research at Pew. “For this to work, states need to have clear policies that ensure that savings can be used to respond to revenue fluctuations driven by the business cycle.”

The study presents three recommendations for states seeking to establish clear guidelines for rainy day fund withdrawals:

1. The fund’s usage should be aligned with its purpose. Not all withdrawals from rainy day funds are consistent with the objectives that the funds were created to meet. States should examine whether funds are meeting their statutory and/or constitutional purpose.
2. There should be a connection between fund withdrawal conditions and volatility. Ideally, guidelines should tie withdrawals to economic or revenue fluctuations in a clear and measurable way. Such guidance gives policymakers a clear signal on whether the time is right to use reserves.
3. The requirements for rebuilding the fund should be clear and achievable. Some states require that any money withdrawn from a rainy day fund be reimbursed within a specific time frame, which is intended to ensure that the state rebuilds its reserves. However, such requirements often fail to take the business cycle into consideration, and in some cases are so stringent that state leaders rarely authorize withdrawals—even in dire economic circumstances.

Failing to set proper guidelines about using rainy day funds can hurt a state’s fiscal health. Between fiscal years 2003 and 2007, most states experienced strong tax revenue growth—over 7 percent on average annually nationwide.  Although this growth could be viewed as an opportunity for states to make deposits to their rainy day funds, 22 states did the opposite and made withdrawals at least once during that time. Conversely, from 2008 to 2010, many states experienced their worst recession-driven revenue downturn in decades—a perfect time for withdrawals—and yet eight did not turn to their rainy day funds at all. In some states, repayment provisions probably discouraged use of these funds. In others, clear conditions for withdrawal were absent.

Historically, many states have used their rainy day funds too frequently during periods of growth, requiring painful cuts in services and tax hikes during economic downturns. Other states have failed to use their funds even during times of great economic and fiscal distress. The establishment of practical, thoughtful policies and withdrawal conditions for rainy day funds can enhance states’ fiscal health over the long term.

The Pew Charitable Trusts is driven by the power of knowledge to solve today’s most challenging problems. Learn more at www.pewtrusts.org.