Rainy Day Funds and Levels of Risk

In its December report Why States Save: Using Evidence to Inform How Large Rainy Day Funds Should Grow, Pew recommends that states identify the level of risk they intend their rainy day fund to cover. But level of risk is a tricky concept.

Annual revenue fluctuates in most states. When it exceeds expectations, policymakers have an opportunity to increase savings or fund additional priorities. When revenue falls, however, they face difficult fiscal choices to balance the budget. But not all revenue downturns are the same. Some are relatively small and reflect only a brief hiccup, while others, such as the Great Recession, can extend for years and present enormous budget gaps for states to address.

Here’s where the level of risk comes in. It is difficult to know how large the next downturn will be. Policymakers must assess how willing they are to risk that the next downturn will be large enough that they are forced to look beyond their rainy day fund to close budget gaps.

Minnesota, for example, clearly defines the level of risk it wishes to offset. Every year, Minnesota Management & Budget examines the state’s historical taxable base to determine how volatile revenue has been over the past 50 years. That volatility is then used to project how large a future revenue downturn might be. Policymakers have decided the state’s reserves should provide complete protection against nine out of 10 possible downturns. With these criteria defined, Minnesota is able to set an informed, evidence-based savings target for its reserves to provide protection against a designated level of risk.

This example underscores the importance of state policymakers deciding how much risk they are willing to accept. If they decide to provide a high level of protection, similar to Minnesota’s, they will be insulated from most revenue downturns, but similar to an insurance policy, the protection comes with a higher savings target. Alternately, if a rainy day fund means to provide less coverage, the savings target will be lower but the state will be at a higher risk of being insufficiently protected from future revenue downturns.

Ultimately, there is no right or wrong for what a state’s budgetary risk tolerance should be. States may opt to guard against more or less risk depending on their spending priorities, obligations, and political cultures. What is most important for setting an optimal size is ensuring that a reserve fund provides a state government with its desired level of insurance against recession-driven budgetary risk.