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Category 2 – Internal, Economic/Technical causes of Financial Distress

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Management challenges
Weak budget development practices
Lack of innovation and adaptability
Poor performance
Poor task-related communication
Ineffective management information systems
Failure to fund & manage retirement benefits prudently
Deteriorating infrastructure

Management Challenges

Challenges with management is a leading cause of financial distress. Management challenges can compound external difficulties or other internal challenges, or even create problems by itself. Below are a few examples of weak management:
  • Narrow vision. An executive may be too focused on day-to-day operations and not be able lead the development of a sound strategy.
  • Inadequate skills or ability. A manager may have risen through the ranks to a position that is beyond their capabilities (i.e., the Peter Principle).
  • Displacement of activity. A manager may focus too much on activities for which they have a natural affinity or skill at the expense of higher-priority, but less satisfying uses of their time.


Symptoms

Management Challenge Image
  • Lack of diversity in viewpoints. This is often experienced as “groupthink.” Groupthink is when individual creativity, uniqueness, and independent thinking are lost in the pursuit of group cohesiveness. 
  • Lack of depth in management team. This could be related to a very strong executive that does not develop subordinates or due to inadequate training, recruitment, or development of management talent. 
  • Succession problems. Management changes can create problems if not handled correctly. Lack of a succession plan is a visible symptom. 
  • Overly bureaucratic management. In an overly bureaucratic environment new ideas die quickly and old work habits persist despite obsolescence. New goals or challenges are not identified and there is an institutionalized contentment with the status quo. This leads to low tolerance for criticism and lack of independent thinking.

Weak Budget Development Practices

Substandard budget practices can contribute to financial distress by:
  • Failing to highlight policies that are unsustainable over the long term
  • Institutionalizing spending patterns and failing to periodically re-examine the reasons behind existing expenditures
  • Failing to provide an adequate system for making cutback decisions.

A cutback environment can severely strain traditional budgeting systems. These systems were often designed under an assumption of continued growth in revenues. Under traditional “incremental” budgeting systems, there is a baseline of spending (often the previous year’s budget) and the purpose of the budget process is to allocate the upcoming year’s new revenue while minimizing analytical effort and political conflict.

Symptoms

  • Across-the-board spending cuts. Equal cuts to all areas are often perceived as “fair.” However, across-the-board cuts are often the symptom of a budget process that does not provide a good means for precisely targeted reductions in spending.
  • Incremental budgeting. An incremental budget system never calls into question the continuing validity of the decisions that lead to existing programs and patterns of resource allocation. A budget should be based primarily on availability of revenues in that budget year, not on the prior year’s expenditures.
  • Budgetary decisions not based on expected service results from programs. A sustainable budgeting process makes resource allocation decisions based on the results that will be achieved for the dollar spent. 
  • Inaccurate revenue and expenditure estimations. Accurate short-term estimates are vital for developing credible and detailed budget plan that can serve as the basis for budgetary control. Look for estimates that vary more than 2-5 percent from actuals, and mismatches between recurring sources and recurring uses.
  • Failure to incorporate reserve policies into budgeting. Budgets should be constructed in full knowledge of how the budgetary plan will impact the organization’s reserves. Continued deficit spending could be one of the tell-tale signs of this problem.
  • Lack of transparent assumptions. Budgets are developed based on certain assumptions such as the rate of inflation, new revenues that will come in, or rates of return on investments. When these assumptions or variables are made explicit and transparent, the organization will more readily recognize and adapt to realities that differ from earlier budgeting assumptions. If budget revisions are not made in a timely manner throughout the year, it may be a sign that budget assumptions are not adequately transparent and managed.

Lack of Innovation and Adaptability

Innovation and adaptability are essential for adjusting to changes in the financial environment. Lack of adaptive behavior hastens decline in an environment of financial distress. Governments must be conscious of developing a process that generates new ideas and sees them through to successful implementation and diffusion to the entire organization.

Symptoms
  • Dysfunctional governing board. Cooperation, mutual trust, and respect between board and staff enable government leaders to focus on achieving policy goals through consensus decision making. In such an environment, innovative approaches to achieving policy goals can be suggested with a higher chance of being considered. Lack of these conditions could stifle innovation.
  • Lack of team management. Team-based management at the senior staff level builds trust and openness. Such an environment lowers the perceived risk of suggesting strategies that go against the established order.
  • Leadership is not credible. Leaders who keep their promises and practice what they preach are perceived as credible. Followers trust such leaders and are motivated by their innovative ideas.

Poor Performance

Contributed by Kristin M. Howlett and Robyn L. Raschke, PhD


Inefficiencies in operations create higher work volumes and lower productivity, often requiring more personnel to do the work. Inefficiency can also sap the public’s confidence in government – if services are perceived to be poor, citizens will be unwilling to pay taxes. Good performance results from the right combination of skilled people, a well-designed process, and enabling technology. Hence, bad performance can result from a failure in any one of these three areas, with people being the most important.

 

Symptoms
  • Poor communication in any direction. Poor communication up or down the chain of command means that performance goals are not made clear and that barriers to the goals are not brought to management’s attention.
  • Well-rounded measures of performance are not used. What gets measured gets managed. If performance is not measured, poor performance is more likely to become a problem. If there are measures, but they are focused just on cost-control, workload, output, or other internal (vs. constituent-centered) issues, then poor performance could be a problem.
  • Lack of formal process improvement initiatives. Processes can become obsolete and people can fail to work effectively within the process. Formal and regular process improvement programs help processes from becoming stale.
  • Lower compensation levels than private-sector counterparts. This could indicate problems of morale or inability to attract skilled labor.
  • Backlog of work is growing (or at least not reducing). This is a clear sign that the current process is not getting work done fast enough.
  • No strategic vision. In the absence of a strategic vision the organization has less clarity on the goals it is supposed to accomplish. 
  • Lack of up-to-date job descriptions. Employees (and their managers) may not have clarity on the tasks they are to perform.
  • No formal training program. New employees may not be properly acclimated to their job and existing employees may continue with bad habits or develop new ones.
  • Proliferation of “shadow systems.” If participants in a process are introducing new spreadsheets and satellite databases into a process, it could indicate a mismatch between the process and its primary enabling technology.

Poor Task-Related Communication 

Contributed by James Garnett

 

Task-related communication during fiscal distress is difficult to achieve and often faulty. Failure to communicate broadly with employees shortchanges their potential contribution to solving the problems.

Miscommunication among departments and public officials leads to inefficiencies that increase costs and reduce revenues. Particularly dangerous are blocks on upward and lateral communication that might bring early warnings of revenue shortfalls or cost overruns.

Lack of communicating with external networks of collateral public agencies, professional associations, nonprofits, and other organizations limits options for sharing costs, risks, or innovations. 

Symptoms
  • Downward communication predominates but lateral and upward communication declines.
  • The pool of ideas for handling fiscal stress dwindles when communication channels dries up.
  • Productivity declines as time and energy are diverted to counterproductive communication: rumors and responding to those rumors.
  • A preponderance of memos, directives, and other official, formal communication occurs at the expense of informal, but task-related communication.
  • Rules and red tape abound, stifling initiative.
  • In spite of or even because of increased red tape, different stakeholders start playing by their own rules and agendas, hindering a common, cooperative approach to resolving problems.

Ineffective Management Information Systems

Limited access to timely personnel, payroll, and budget control data and reports impedes management’s ability to make sound decisions. Modern information systems can provide this information, automate control systems, and reduce time spent on routine transaction processing.

Symptoms
  • Lack of training. Staff may not be trained to use the existing technology. They may not use the technology to its full potential or may develop manual work-arounds outside of the system.
  • Fragmentation. Needed information is spread across many different systems, making it difficult or impossible to aggregate data into reports.
  • Obsolete technology. The current system may not be capable of easily producing desired reports, flexible chart-of-accounts administration (e.g., for cost accounting), or process automation.
  • Lack of IT governance. Decision-rights and accountabilities for investing in technology and getting value from those investments are ill-defined.

Failure to Fund & Manage Retirement Benefits Prudently

Contributed by Girard Miller 

 

Some retirement plans now face financial stress because they promised too much; others have promised reasonable and competitive benefits, but their management was insufficient: they failed to fund the benefits properly and control abuses of their benefits. 

In the case of OPEB plans for retiree medical benefits, the vast majority of public employers nationally have relied on pay-as-you-go financing, which worked just fine in the early years when the number of beneficiaries was very small. But as Baby Boom workers near retirement, the prospects of benefits payments doubling or tripling in the next ten years is a clear sign that the plan is unsustainable. For employers that offer a substantial retirement medical benefit, only an actuarial funded plan will be sufficient.

In the pension world, a variety of actuarial techniques have been employed to defer costs.  For example, the average public pension plan amortizes its unfunded liabilities over 20-25 years, and some go as far as 30 years under current accounting standards. Yet very few public workers serve a full 30-year career. 

All pension and OPEB funding gimmicks ultimately come down to this problem: pay now and earn the investment returns (especially when financial markets are still depressed and prices are lower than when the economy recovers), or pay more later.

Finally, there are issues with plan management, such as pension spiking. Likewise, some jurisdictions have unreasonably high rates of disability retirements, in which safety officers exploit the tax incentives to retire on disability to avoid income taxes.

Symptoms
  • High percentages of early retirements, pension spiking, and disability retirements.
  • The plan’s amortization practices are unrealistic (e.g., 30 years), in light of much-shorter average expected remaining service lives of employees (e.g., 10-14 years).
  • The plan uses methods that might require higher future contributions after employees have already retired. These include deferred actuarial amortization, or smoothing periods that exceed the average expected service lives of current employees. 
  • There is a chronic history of declining actuarial funding ratios over market cycles.
  • The OPEB plan is funded on a pay-as-you-go basis rather than an actuarial basis – with projected benefits disbursements scheduled to double or triple in 10 years.
  • Investment return assumptions exceed the national average for plans of similar size. Trust fund portfolios repeatedly fail to achieve assumed returns. 
  • Taxpayer groups or media outlets frequently bring attention to abuses and excesses.

Deteriorating Infrastructure

Infrastructure is vital to fiscal health because it provides direct services and supports wealth creation in the community. Deteriorating infrastructure can lead to fiscal distress as maintenance needs compound, requirements for new infrastructure mount, and existing facilities become increasingly unsafe and unsound.

Symptoms

  • Continually deferred maintenance
  • Backlog of maintenance projects
  • Increasingly poor safety record or lawsuits
  • Loss of economic development due to poor infrastructure
  • Inadequate investment as measured by backlog of capital projects or extremely low levels of debt

Continue to Category 3 – External, Political Causes of Financial Distress

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