When the California State Auditor’s Office released its annual report on the “Fiscal Health of California Cities” in fall 2022, most city officials and journalists focused on the blunt financial risk rating results and the relative position of their city organization amongst the 431 cities analyzed. But there is more that we can learn from the report by reflecting on what it says and does not say about the financial condition of California cities. Local residents and business owners would benefit greatly if the report were viewed as a call to action and not a snapshot evaluation to be consumed and discarded. As cities submit their financial statements for this year’s report, there are some actionable takeaways from the 2022 report that city officials should consider.

As a result of its analysis, the state auditor classified only five California cities as “high risk.” This result is encouraging because it is down from the 13 high risk cities reported in 2021. Unfortunately, the improvement was short-lived for two reasons. The robust CalPERS investment returns of 2021 increased pension funding levels, but only temporarily. Meanwhile, the influx of funds from the 2021 federal relief (ARPA) bolstered local and state cash reserves throughout the country, also temporarily. The combined effect of these two factors was to raise the financial tide for cities across the state and for the state itself as these agencies prepared their budgets for the current fiscal year (2022-23).

City officials should consider the state auditor’s financial risk assessment in the current context as cities prepare their budgets for 2023-24. Recent economic growth has been sluggish, and the country is experiencing its highest inflation rates in four decades. This first factor will dampen local revenues and future CalPERS investment returns, while the latter will spur increases in employee compensation along with higher capital and utility-related costs.  

Limitations of the report

The state auditor’s report uses several weighted criteria (reserves, debt, liquidity, revenues, pension, and other retiree obligations) to score cities on a scale of 0 to 100. Cities with low scores are considered to have significant risk of fiscal stress and are designated “high risk.” 

Conspicuously missing from the scoring criteria is a category that addresses deferred maintenance. The condition of city-maintained infrastructure and other assets (e.g., sidewalks, streets, parks, utilities, etc.) is critical to the quality of life for residents and affects the city’s future costs. However, many cities are only able to maintain satisfactory reserves, liquidity, and pension funding by foregoing maintenance of the infrastructure and other assets for which they are responsible. Although it is irresponsible and reckless for a city to defer major maintenance, cities are not accountable for such lapses under the scoring criteria. 

Astute observers will recognize the time lag associated with the report. The state auditor’s 2022 analysis is based on city financial statements as of June 30, 2021. Notably, this reporting date was too early to capture the estimated CalPERS investment loss of 6.1% realized in the subsequent year (ended June 30, 2022). Such relevant information is worthy of inclusion as a footnote to the report. Meanwhile, CalPERS investment earnings in the current fiscal year (ending June 30, 2023) are not on track to reach the target 6.8% annual return.

Pushback against state auditor’s ratings

A few cities have taken issue publicly with the state auditor’s ratings. A report by the Los Angeles Daily News noted three cities (Montebello, Torrance, and Redondo Beach) whose leaders cited payments toward pension obligations as evidence that their city’s fiscal health had improved. However, the three cities made these pension contributions with borrowed funds (i.e., pension obligation bonds), simply substituting bond debt for pension funding obligations. 

These cities all continue to bear the risk that CalPERS’ future investment returns prove insufficient to fund their defined benefit pension plans. At best, pension obligation bonds reduce the overall cost of pension benefits over a period of decades. At worst, they lend credibility to the false evaluation that a municipality has solved its pension funding problems. 

Zombie cities

To the state auditor’s credit, its website calls out cities that are delinquent in preparing their 2020-21 audited financial reports. Such cities had no useful information to contribute to the 2022 report. In a disturbing trend, the number of cities with severely delinquent or deficient financial reporting grew from six in 2018-19 to eighteen in 2019-20 to fifty-two in 2020-21. Thus, 12 percent of California cities are adopting budgets and managing their complex organizations without current, reliable financial information. 

Delinquent financial audits increase the likelihood that the condition of a struggling city’s general fund is obscured by the city’s use of other funds (e.g., water funds, grant funds, or other special purpose funds) to maintain a positive bank account balance. Such cities can be financially insolvent yet unaware of the extent of their fiscal emergency. 

The state auditor’s 2022 report rated 102 cities high risk with respect to their pension costs.This result means that each of these cities’ “actuarially determined pension contributions constitute a significant portion of its revenues and will likely strain its financial resources.” The report also rated 291 cities high risk with respect to their OPEB (retiree medical) costs. This result means that these cities’ OPEB plan(s) do not “have sufficient assets to fund a substantial portion of the other post-employment benefits.” 

In the private sector, when a company only generates sufficient income to cover its operating costs and interest on its debt, it is called a zombie company. We now have a similar phenomenon in local government: zombie cities, where revenues are only sufficient to cover their operating costs and debt service, and they are unlikely to ever extinguish their pension and OPEB obligations or catch up on deferred maintenance. 

Zombie companies die off when interest rates rise and/or credit markets tighten. This is good for the economy because it results in more efficient allocation of investment capital. Zombie cities put off municipal death (i.e., disincorporation) by reducing service quality, deferring maintenance, implementing serial tax increases, borrowing from utility or other enterprise funds, and even appealing to the authority of the bankruptcy courts — none of these strategies are good for local residents and businesses. 

So what should cities be doing? 

The resuscitation of our overextended, zombie cities demands more than the superficial corrective measures to which cities are accustomed.

First, city officials should prioritize the timely production of their financial statements. Without current, audited financial information, city staff are simply unable to provide their city councils and residents with reliable budgets or coherent assessments of their organization’s financial condition. 

Second, cities should perform a rigorous review of the activities they have taken on, using a clear standard to evaluate which activities should continue — i.e., they should scrutinize why they do what they do, particularly when they are failing to deliver. City officials should phase out those commercial and charitable activities for which private for profit and nonprofit organizations are the appropriate providers.  

Finally, cities need to rethink how they are delivering services. Providing local services in the 2020s with legacy personnel systems (including antiquated job descriptions and civil service and civil service-like hiring and discipline structures) and legacy service delivery systems (which are difficult to change because of the legacy personnel systems) is not working. It is not working administratively or financially for the cities, and it is not working in the quality of services delivered to residents. 

The next state auditor’s report

In a special report released in late 2022 for one high-risk city, the state auditor recommended that the distressed city adopt “a fiscal sustainability plan by July 2023 that contains specific measures for increasing revenues, decreasing expenditures, and eliminating fund deficits.” [source here] Presumably, such a plan would mark the city’s first step in improving its financial risk profile.

But the state auditor’s advice may itself constitute a high-risk proposition. A narrow focus on revenues, expenditures, and fund balance improvements is not enough. By not challenging the city to review why it does what it does and, then, how it does it, such advice reinforces the city’s futile attempt to preserve its status quo scope of activities. Municipal fiscal sustainability plans invariably attempt to sustain the organizations as they are — i.e., with their ambitious, creeping missions supported by legacy personnel, administrative, and service-delivery systems.

If cities fail to engage fully in the question of what they should do and, after resolving that question, evaluate how they should do it, the 2023 state auditor’s report on the fiscal health of cities will reveal more high-risk, zombie cities.

Mark Moses is a senior fellow with California Policy Center. He has thirty years of experience in local government administration and finance. His recent book, “The Municipal Financial Crisis – A Framework for Understanding and Fixing Government Budgeting,” was published by Palgrave Macmillan in January 2022 and is available from major online booksellers.

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