compact cofa cpi ctf fsm gdp jemfac rmi rop · iv e. comparison of the different rules 29 f. cofa...

ii

CURRENCY EQUIVALENTS

Currency unit: United States dollar (US$)

ABBREVIATIONS

ADB — Asian Development Bank

amended Compact — second phase of the Compact, FY2004–FY2023

Compact — RMI Compact of Free Association with the US

COFA — Compact of Free Association

CPI — Consumer Price Index

CTF — Compact Trust Fund

FSM — Federated States of Micronesia

GDP — gross domestic product

JEMFAC — Joint Economic Management and Financial Ac-

countability Committee

RMI — Republic of the Marshall Islands

RoP — Republic of Palau

US — United States

Note: The FAS government fiscal year (FY) ends on September 30.

iii

TABLE OF CONTENTS

Page

Table of Contents iii

List of Tables vi

List of Figures vii

Foreword ix

I. Introduction and Executive Summary xi

1. Introduction xi 2. Executive Summary xiii

II. Trust Fund Dynamics 1

1. Introduction 1 2. The Structure of the FSM and RMI Trust Funds 3 3. The Structure of the RoP Trust Fund 4

4. Trust Fund Principles 4 5. Market Risk 6

6. Benchmarks and Performance Measures 7 7. Trust Fund Simulations 9 8. Moving Adjustment Rule (MAR) 10

9. The Sustainability Rule (SR) 10

10. The Sustainability Adjustment for Enhanced Reliability Rule

(SAFER) 12

III. The FSM Compact Trust Fund 14

A. Performance of the Compact Trust Fund (FY2004–FY2017 and Projected

through FY2023) 14 1. Background 14 2. Performance Monitoring 15

B. Simulating the CTF under the COFA Rules 18 1. Trust Fund Performance 18 2. Volatility 20

C. Moving Adjustment Rule (MAR) 23 1. Trust Fund Performance 23

2. Volatility 24

D. The Sustainability Adjustment for Enhanced Reliability (SAFER) Rule 26 1. The Sustainability Rule (SR) 26 2. The Sustainability Adjustment for Enhanced Reliability Rule

(SAFER) 28

iv

E. Comparison of the Different Rules 29 F. COFA plus SAFER 32 G. The FSM Trust Fund 32

1. FSMTF Rules 33

2. Performance of the FSMTF 33

H. Increasing Contributions 34

IV. The RMI Compact Trust Fund 42

A. Performance of the Compact Trust Fund (FY2004–FY2017 and projected to

FY2023) 42 1. Background 42 2. Performance Monitoring 43

B. Simulating the CTF under the COFA Rules 46 1. Trust Fund Performance 46 2. Volatility 47

C. Moving Adjustment Rule 51 1. Trust Fund Performance 52 2. Volatility 52

D. The Sustainability Adjustment for Enhanced Reliability (SAFER) Rule 54 1. The Sustainability Rule (SR) 54 2. The Sustainability Adjustment for Enhanced Reliability Rule

(SAFER) 56

E. Comparison of the Different Rules 58 F. COFA plus SAFER 60

G. Increasing Contributions 60

V. The RoP Trust Fund 67

A. Compact Trust Fund Performance (Analysis Based on Data through

FY2017) 67 1. Background 67 2. CTF Performance 68

3. Looking Forward: The Importance of the Compact Review

Agreement 69

B. Simulating the CTF under the COFA Rules 71 C. Moving Adjustment Rule 74 D. The Sustainability Adjustment for Enhanced Reliability (SAFER) Rule 76

1. The Sustainability Rule (SR) 77

2. The Sustainability Adjustment for Enhanced Reliability Rule

(SAFER) 77

v

E. Increasing Revenue Effort: The RoP++ Rule 79 F. Comparison of the Different Rules 81

VI. Conclusions 85

Appendix 1 Technical Notes to the FSM and RMI Simulations 87

1. Market Financial Data and Simulations 87 2. Specification of the Alternative Rules 88

vi

LIST OF TABLES

Page

Table 1 US annual contributions to the FSM and RMI: sector grants and

trust funds 2

Table 2 Annual US contributions to the RoP for budgetary support and

trust fund, and permitted trust fund drawdowns 2

Table 2 Annual US contributions to the RoP for budgetary support and

trust fund, and permitted trust fund drawdowns 3

Table 3 Summary of the moving adjustment rule, sustainability rule, and

SAFER rule 13

Table 4 FSM Compact Trust Fund simulated results and performance 19

Table 5 FSM Compact Trust Fund simulations: running COFA under

SAFER 32

Table 6 FSM Trust Fund simulations comparing performance under the

COFA, SAFER and FSM rules 34

Table 7 Augmenting trust fund resources: performance results 37

Table.8 RMI Compact Trust Fund simulated results and performance 47

Table 9 RMI Compact Trust Fund simulations: running COFA under

SAFER 61

Table 10 Augmenting trust fund resources: performance results 63

Table 11 Estimated renewed Compact schedule of contributions and

drawdowns 72

Table 12 RoP Compact Trust Fund simulated results and performance under

the COFA rules 73

Table 13 RoP Compact Trust Fund simulated results and performance under

alternative rules 75

Table A1 Financial data: statistical estimates of means, standard deviations,

and correlations 88

vii

LIST OF FIGURES

Page

Figure 1 Return on Investment in U.S. Stocks and Bonds 6

Figure 2 Overall CTF Performance at different levels of funding to the

Primary Target 11

Figure 3 Projected FSM Trust Fund Value through FY2023 17

Figure 4 Probability Distribution of FSM Compact Trust Fund in FY2023 18

Figure 5 Distributions by number of cases falling in selected ranges under

COFA rules 20

Figure 6 Randomly selected CTF trajectories and drawdowns 22


MAR rules 24

Figure 8 selected CTF trajectories and drawdowns under the MAR Rules 25


SR rules 27


SAFER rules 29

Figure 11 Comparison of distributions under the different rules 31


the FSM rules 35

Figure 13 Probability Distribution of the Compact Trust Fund with FSM

contributions 36

Figure 14 Comparison of distributions under different FSM contribution

regimes 41

Figure 15 Projected RMI Trust Fund Value through FY2023 45

Figure 16 Probability Distribution of RMI Compact Trust Fund in FY2023 46


COFA rules 48

Figure 18 Randomly selected CTF trajectories and drawdowns 50


MAR rules 52

Figure 20 Randomly selected CTF trajectories and drawdowns under MAR 53


SR rules 56


SAFER 57

Figure 23 Comparison of distributions under the different rules 60

viii

Figure 24 Probability Distribution of the Compact Trust Fund with RMI

Contributions 62

Figure 25 Comparison of distributions under different RMI contribution

regimes 65

Figure 26 Original projected CTF values –vs– actual 68

Figure 27 CTF projections completed at end of 15th year 69

Figure 28 CTF projections with and without approved review agreement 70

Figure 29 Probability Distribution of RoP Compact Trust Fund in FY2024 72


the renewed Compact 74


the Moving Average Rule 76


the Sustainability Rule (SR) 78


the SAFER Rule 79

Figure 34 Probability Distribution of the Compact Trust Fund with RoP

contributions 80


RoP++ 81

ix

FOREWORD

This study has been prepared to bring together the various pieces of work undertaken by

the Graduate School USA (GSUSA) on the Compact Trust Funds of the Federated States

of Micronesia (FSM), Republic of the Marshall Islands (RMI) and Republic of Palau

(RoP). The Graduate School USA team is fortunate to possess expertise in financial-mar-

ket analysis, statistical-modeling techniques, and macroeconomic and fiscal-policy analy-

sis. It is thus well positioned to analyze the current performance of the FAS CTFs, simu-

late likely future outcomes and tie this back into the emerging fiscal structure and chal-

lenges of the respective nations.

Given the prominent role of the CTFs in the future of the three Freely Associated States,

monitoring and tracking of the funds has been a key feature of the annual economic re-

views prepared for each nation. As time advanced, it became apparent that the funds were

unlikely to achieve their objectives, and the Graduate School USA team focused on simu-

lating the performance of the CTFs during the operational phase and their suitability to

purpose. This study thus incorporates an analysis of the performance of each of the CTFs

since the inception of each fund and is forward looking on the potential to provide a se-

cure and sustainable flow of resources to support government operations in the future.

This study contains four main chapters: an initial chapter that deals with issues common

to each of the three CTFs, and three country-specific chapters, each of which looks in de-

tail at the specific country fund. The common chapter focuses on the structure and design

of the trust funds and discusses the principles each of the funds is expected to address. A

brief discussion of market risk is provided to set the stage, followed by a selection of per-

formance measures each fund is scored against. The methodology adopted in this study

utilizes Monte Carlo analysis and simulation techniques. A set of alternative rules is pro-

posed to improve performance on the existing Compact of Free Association (COFA)

rules.

Each of the country chapters starts with a detailed analysis of the historical background

and performance of each of the CTFs since its establishment. This is followed by simulat-

ing the performance of the funds during the operational phases under the existing rules

specified in the Compacts and their subsidiary agreements. Since the results under exist-

ing rules are not fully favorable, performance is assessed against alternative methodologi-

cal specifications. Finally, in each FAS, consideration is given to augmenting the CTFs

with additional funds.

This study has been prepared under a grant from the Department of the Interior and is ad-

ministered through the Graduate School USA. It has been prepared by Mark Sturton, and

supported by the Graduate School team. Extensive discussions were also held with Mi-

chael Wulfsohn, consultant to the ADB, who prepared a valuable study of the FSM and

RMI Trust Funds for the bank. Extensive technical collaborative discussions have also

been held with the US Government Accountability Office.

x

This study and the author’s initial work in this area (EMPAT Technical Note, Compact II

Trust Fund Agreement: Principles and Problems, November 3, 2002) are available online

at http://econ.pitiviti.org.

http://econ.pitiviti.org/

xi

I. INTRODUCTION AND EXECUTIVE SUMMARY

1. INTRODUCTION

The introduction of a trust fund into the Compacts between the US and the three Freely

Associated States (FAS) first arose in the case of the RoP. For Palau, the original Com-

pact was for a 50-year period with an initial 15 years of economic assistance from

FY1995 to FY2009. The provisions included a trust fund with a contribution of $66 mil-

lion in FY1995 and a further $4 million in the subsequent year of FY1996, thus totaling

$70 million. From the outset of the fifth year under the Compact, Palau was entitled to

begin annual drawdowns of $5 million over the period FY1999–FY2009, and thereafter a

further $15 million annually during the remainder of the 50-year Compact period through

FY2044. The COFA Trust Fund was designed as a sinking fund for the duration of the

Compact. A major assumption in the design of the RoP CTF was that investment returns

would be 12.5 percent annually. This was, at least in retrospect, a virtually unachievable

assumption. Primarily because of the shortfall in the RoP CTF relative to the growth as-

sumptions, in 2010 agreement was reached between the US and Palau for extending the

Compact financial-support arrangements (the Compact Review Agreement). Given the

projected failure of the CTF to achieve its purpose, a further 15-year funding term was

agreed, with additional funds for the CTF and a reduced rate of drawdown from the CTF

by way of budgetary support and other categories of financial support. The RoP received

stop-gap funding for the period FY2010–FY2018, awaiting US Congressional approval,

which was finally granted in March 2018, for funding under the agreement to begin at the

outset of FY2019. Still, even with the extended review agreement, the RoP CTF remains

a sinking fund despite an express desire on the part of Palau’s leadership to have (or ulti-

mately achieve) a perpetual fund with a focus on intergenerational fairness.

In the cases of the FSM and the RMI, the inclusion of trust funds arose during the negoti-

ations of the amended Compact, designed to provide assistance during FY2004–FY2023.

The structure of the two Compacts provided a fixed flow of resources each year over the

20-year period, partially adjusted for inflation. Out of the annual flows, a reduced “decre-

mented” amount was allocated as sector grants for the support of government operations

and an increasing proportion was allocated to the CTFs. The design of the CTF was to

provide a fully inflation-adjusted flow of resources equivalent to the anticipated terminal-

year annual sector grants in FY2023. While there was no guarantee that the respective

funds would achieve this goal, the Palau and FSM/RMI funds had very different objec-

tives. The Palau fund was designed as a sinking fund to provide support, as long as it

lasted, to current generations. The FSM and RMI funds were designed as perpetual funds

with the emphasis on support favoring maintenance of the CTF corpus and future genera-

tions.

xii

Since FY2005, the Graduate School USA has prepared an annual economic review of the

FSM and RMI, and in the case of Palau the first review was prepared for FY2012.1 In

each of these reviews, a key section was introduced to monitor and track the performance

of the respective funds. As time progressed, it became apparent that the funds would be

unlikely to fully and sustainably achieve their purpose, which thus presented a risk to the

economic stability of the FSM and RMI after FY2023. From an analysis of the past per-

formance, the GSUSA work switched to a forward-looking risk assessment of the CTFs.

This built upon work by the GAO in 2007 and by the ADB in 2015.2 In the FY2015 eco-

nomic reviews, the analysis included both a section tracking performance and a section

on simulations of the potential to provide a secure and sustainable flow of resources after

FY2023. The reviews further made projections of likely economic and fiscal performance

based on current trends and policies. Given the inherent weaknesses exposed in the funds,

the reviews proposed additional country (or third-party) contributions as a means of mak-

ing the funds well suited to their purpose.

This study has been prepared to bring together the various pieces of work undertaken by

the Graduate School USA on the Compact Trust Funds of the Federated States of Micro-

nesia, Republic of the Marshall Islands and Republic of Palau. As noted, this study con-

tains four main chapters: an initial chapter that deals with issues common to each of the

three CTFs, and three country-specific chapters. The reader interested in a specific coun-

try should thus read the common chapter and focus on the country chapter of interest.

The common chapter focuses on the structure and design of the trust funds and discusses

the principles each of the funds should address: (i) maintaining the real value of the cor-

pus, (ii) providing a steady flow of annual distributions, and (iii) avoiding volatility in

distribution. A brief discussion of market risk is provided to set the stage and is followed

by a selection of measures to score fund performance. For each of the three principles,

two performance measures have been chosen, and an overall performance indicator is de-

fined. The methodology adopted in this study closely follows that in the two other studies

of the FSM and RMI. Monte Carlo analysis and simulation techniques are utilized. A set

of alternative rules is proposed to improve performance on the existing Compact (COFA)

rules: a moving adjustment rule (MAR) that indexes distributions to the size of the trust

fund, a sustainability rule (SR) that aligns distributions with trust fund sustainability, and

a sustainability adjustment for enhanced reliability (SAFER) rule that specifies draw-

downs to achieve a high probability of a strong performance score.

1 The Graduate School USA, Republic of Palau Fiscal Year 2016 Economic Review, Federated

States of Micronesia Fiscal Year 2016 Economic Review, and Republic of the Marshall Is-

lands Economic Review 2016, Honolulu, HI; http://econ.pitiviti.org. 2 See US Government Accounting Office, Trust Funds for the Micronesian and the Marshall

Islands May Not Provide Sustainable Income, GAO-07-513, June 2007, Washington, DC.

Asian Development Bank, Trust Funds and Fiscal Risks in the Federated States of Microne-

sia and the Marshall Islands: Analysis of Trust Fund Rules and Sustainability in an Evolving

Aid Relationship, 2015, Manila.

http://econ.pitiviti.org/

xiii

Each of the country chapters starts with a detailed analysis of the performance of each of

the CTFs since its establishment. This is followed by simulating the performance of the

funds during the operational phases under the existing rules specified in the Compacts

and their subsidiary agreements. Since the results under COFA rules are not fully favora-

ble, the three alternative rules—MAR, SR and SAFER—are simulated and assessed

against the performance indicator “scorecard.” While there is considerable improvement

under the alternative rules, performance is still not adequate to attain a level that would

result in a high degree of confidence that the CTFs will provide a sustainable level of re-

sources for future generations. The analysis draws on the recent FY2016 economic re-

views, the emerging structural fiscal surplus in the FSM and RMI, and the potential for

enhanced revenue effort in the RoP. The resulting—but still just potential—flows into

their respective CTFs are incorporated into the analysis as a set of “++” rules. An appen-

dix is provided with the technical specifications of the simulations under the different

rules.

2. EXECUTIVE SUMMARY

FSM and RMI CTF Design Issues: Certain design characteristics of the mutually agreed

CTF distribution mechanism require the attention of the CTF Committees in collabora-

tion with the US, FSM and RMI governments. Modifications to the CTF Agreement that

may be needed include the following:

redesigning problematic design characteristics of the buffer-account mechanism;

revising a distribution mechanism that results in timing that conflicts with the pre-

vailing practice of estimating annual allocation decisions each January and con-

firming them each August in advance of the subject fiscal year; and

designing distribution rules that could better protect the real value of the corpus

over the long run while also reducing the volatility of distribution levels and re-

ducing the frequency of shortfalls in annual fiscal support to the FAS.

Changes to the agreement itself, of course, require approval by the US Congress.

Core CTF Principles: CTF core principles are defined as follows:

1. The real (inflation-adjusted) value of the trust fund should be protected (over the

long run).

2. The trust fund should provide a secure and stable source of revenues to the gov-

ernments of the FAS on an annual basis.

3. Annual distributions should entail minimal volatility from period to period and,

when volatility is required, the volatility should be of known magnitude to limit

disruption to fiscal policy.

A series of performance measures is defined for each principle, and an overall perfor-

mance indicator combining the individual results is constructed. Simulations are con-

ducted using Monte Carlo statistical techniques based on a simple portfolio composed of

xiv

equities and bonds. The value of the CTF is projected through FY2023 as the corpus ac-

cumulates, and both drawdowns and fund corpus are projected through FY2050.

In the discussion, three useful benchmarks are defined:

i. The target distribution is defined in the Compact Trust Fund Agreement as

the real value of the FY2023 (FSM and RMI) and FY2024 (RoP) grant-assis-

tance levels plus full inflation adjustment.

ii. The primary-target fund estimate is defined as the value of the CTF required

to yield the target distribution in a given year based on the estimated real geo-

metric portfolio rate of return.

iii. The sustainability target is defined as the primary target multiplied by an

empirically estimated adjustor to reduce fund-failure risk due to market risk to

an acceptable level.

Alternative Accumulation and Distribution Rules: The simulations examine alternative

rules to improve on the existing distribution rules specified in the Compact Trust Fund

subsidiary agreement. Three rules are considered: (i) a moving adjustment rule (MAR),

which indexes distributions to the size of the trust fund, (ii) a sustainability rule (SR),

which aligns distributions with trust fund sustainability, and (iii) a sustainability adjust-

ment for enhanced reliability (SAFER) rule, which specifies initial and subsequent draw-

downs to achieve an empirically optimized value using the performance-indicator score-

card.

i FSM

CTF Performance: The FSM CTF continued its pattern of growth at or near market per-

formance. During the investment period since the outset of FY2007, the annualized rate

of return has been 6.87 percent. The estimated value as of the end of FY2017 was $564

million. Assuming only the planned US contributors to the CTF, the fund would need to

grow at 5.1 percent annually from FY2018 to FY2023 to achieve a level sufficient to pro-

vide a smooth transition to CTF distributions from FY2024 onward at the real value of

sector grants that terminate at the end of FY2023. As unlikely as achieving such a sus-

tained growth rate may be, achieving such a level would not mean the risk of subsequent

periodic fiscal shocks would be eliminated. Such a risk primarily results from the funda-

mental reliance upon market returns, which carries with it volatility.

Simulating Accumulation and Distributions from the FSM CTF: The simulations indi-

cate that in FY2023, the FSM CTF is likely to only exceed the projected primary-target

value of $1,655 million in 7 percent of cases and attain a median value of $1,139 million,

31 percent below the primary target. It is further simulated that in 72 percent of cases, the

distribution will be zero in one or more years between FY2024 and FY2050. The median

result would be disastrous in terms of fiscal impact and indicates that without remedial

action, the FSM is headed for massive and repeated fiscal shocks after FY2023. The

overall indicator of CTF performance scores 43 percent.

xv

A considerably higher score on the performance indicator and reduced volatility can be

achieved through adopting any of the alternative accumulation and distribution rules, but

at the cost of reduced levels of annual distributions. Under the alternative rules, the CTF

performance is increased to 61 percent under MAR, 65 percent under SR, and further un-

der SAFER to 72 percent. While volatility is significantly dampened under these rules,

there remains a small probability of CTF collapse.

Additional contributions are needed to ensure the CTF reaches sustainable levels and ful-

fills its mandate. This can be attained if the FSM national government devotes its boom-

ing revenues to shoring up the CTF before FY2024 and thereafter to supporting the level

of government operations at the state level. A variety of different options are simulated to

examine the impact of additional FSM funds. These include contributing the additional

resources to the COFA trust fund, implementing FSM public law PL19-67, contributing

the funds to a trust based on SAFER++, and simple use of FSM funds to augment COFA

trust fund shortfalls (known as the buffer rule). Augmenting the existing COFA fund and

implementing PL19-67 both display the same underlying weakness of the existing ar-

rangements, with significant volatility in drawdowns. Both SAFER++ and buffer gener-

ate the best results, each attaining a score of 90.

ii RMI

Compact Trust Fund Performance: The RMI CTF continued its pattern of growth at or

near market performance. During the investment period since the outset of FY2006, the

annualized rate of return has been 6.75 percent. The estimated value as of the end of

FY2017 was $355 million. Assuming the pledged contributions from the Republic of

China continue, the fund would only need to grow at 2.7 percent annually from FY2018

to FY2023 to achieve a level sufficient to provide a smooth transition to CTF distribu-

tions from FY2024 onward at the real value of sector grants that terminate at the end of

FY2023. However, achieving such a level does not mean the risk of subsequent periodic

fiscal shocks is eliminated. Such a risk primarily results from the fundamental reliance

upon market returns, which carries with it volatility.

Simulating Accumulation and Distributions from the RMI CTF: The simulations indi-

cate that that in FY2023, the RMI CTF is likely to exceed the projected primary-target

value of $544 million in 87 percent of cases and attain a median value of $715 million, 31

percent above the primary target. While this result looks favorable, it is far from fully sat-

isfactory. In 35 percent of cases, the simulations project a zero distribution in at least one

year between FY2024 and FY2050. The overall indicator of CTF performance scores 81

percent.

Reduced volatility and a higher score on the performance indicator can be achieved

through adopting the MAR and SAFER accumulation and distribution rules, but at the

cost of reduced levels of annual distributions. Under these two rules, the CTF perfor-

mance is increased to 87 percent under MAR and further under SAFER to 88 percent.

xvi

Surprisingly, the result for SR, at 78 percent, is below COFA. While volatility is removed

under these rules, there remains a small probability of CTF collapse.

RMI contributions to the CTF to further improve performance are considered. The emer-

gence of a structural fiscal surplus from booming fishing revenues provides an important

source for shoring up the CTF before FY2024. A variety of different options are simu-

lated to examine the impact of additional RMI funds. These include contribution of the

additional resources to the COFA Trust Fund, contribution of the funds to a trust based

on SAFER++, and simple use of RMI funds to augment COFA Trust Fund shortfalls

(known as the buffer rule). Augmenting the existing COFA fund continues to display the

same underlying weakness of the existing arrangements, with significant volatility in

drawdowns. SAFER++ and buffer generate the best results, attaining scores of 94 and 95

percent, respectively.

iii Palau

Compact Trust Fund Performance: The RoP CTF continued its pattern of growth at or

near market performance. During the investment period from the outset of February 1995

through FY2017, the annualized rate of return has been 7.79 percent. The audited value

as of September 30, 2017, was $219.8 million. The investment rate of return the CTF

achieved through the end of FY2009 was 7.47 percent, slightly better than the estimated

performance of the CTF’s unmanaged, cost-free blended benchmark return of 7.32 per-

cent over the same period. Still, that result, which would be deemed successful in the

world of institutional investing, fell far short of the assumed rate of return of 12.5 percent

that was built into the Compact from the outset.

Design of the Original and Renewed Compact: An enlightened feature of the original

Compact was the creation of a trust fund. The CTF was intended to provide $5 million

annually from FY1999 to FY2009 and then $15 million annually for government opera-

tions through the Compact’s 50th year in FY2044. However, as mentioned above, these

projections were based on the CTF achieving an annual return of 12.5 percent. Despite

index-benchmark-beating returns, the balance of the RoP at the end of FY2009 was $144

million. This was far from sufficient to yield a $15 million annual drawdown over the pe-

riod FY2010–FY2044. Based on projections made at the end of FY2009, the CTF faced a

high probability that it would fail to achieve its original objectives if the financial terms

of the Compact remained unchanged. As a result of the required Compact section 432 re-

view, an agreement was reached in 2010 between the US and the RoP to renew the eco-

nomic-assistance terms of the Compact. The agreement sought to reduce planned with-

drawals and to deposit additional funds into the CTF from FY2010 to FY2024. Unfortu-

nately, only stop-gap annual funding has been provided from FY2010 to FY2018, with

further funds awaiting authorization and appropriation by the US Congress. Effective

March 23, 2018, those long-awaited actions have been taken. As passed, funding will

begin at the outset of FY2019. After accounting for stop-gap funding already provided,

the parties to the agreement are now required to reformulate the schedule of assistance to

account for the delay and, presumably, to make the RoP whole with respect to the review

xvii

agreement during the period FY2019–FY2024. Subject to a sensible but modified execu-

tion of the review agreement, current projections indicate a strong likelihood that the CTF

will achieve and even significantly exceed the original objectives. The CTF will persist,

albeit at a slowly declining level, beyond FY2044.

Simulating Accumulation and Distributions from the RoP CTF: The RoP COFA Trust

Fund was originally designed as a sinking fund favoring current generations with a fixed

nominal drawdown until fund collapse. In the basic simulation, the arrangements have

been modified to provide a constant drawdown of $15 million adjusted for inflation,

while the simulations have been scored against the three principles outlined above to give

equal weight to both current and future generations. The simulations indicate that in

FY2024, the RoP CTF is likely to exceed the projected primary-target value of $301 mil-

lion in 57 percent of cases and to attain a median value of $317 million, 5 percent above

the primary target. While this result looks favorable, it is far from fully satisfactory. In 9

percent of cases, the fund collapses before FY2044. The overall indicator of CTF perfor-

mance scores 81 percent.

A higher score on the performance indicator can be achieved through adopting any of the

alternative accumulation and distribution rules. Fund collapse is avoided, but at the cost

of reduced levels of annual distributions. Under the alternative rules, the CTF perfor-

mance is increased to 84 percent under MAR, 82 percent under SR, and further under

SAFER to 86 percent. The FY2016 RoP economic review examined a reform strategy in-

cluding implementing revenue-neutral tax reforms. However, in this study we examine

the case where the RoP implements a tax-reform strategy and uses its increased powers to

generate a revenue effort of 2.5 percent of GDP to contribute to the CTF. Under the re-

form strategy, CTF performance attains 97 percent. After several years of inactivity, the

tax-reform initiative is now actively being considered, and the simulations indicate the

likely size of the revenue effort required to support attaining a sustainable perpetual trust

fund.

iv Recommendations

1. Reform of Compact Subsidiary-Agreement Accumulation and Distribution Pol-

icy: It is clear from the analysis presented in this study that the COFA rules con-

tained in the FSM and RMI amended Compacts allow for untenable (maximum)

distributions to replace the existing sector grants. Volatility is extreme, producing

many cases of reduced or zero distributions. Accordingly, the COFA rules, when

viewed from the perspective of fiscal policy, are undesirable. The preferred out-

come is for agreement to be reached between the original parties to (i) eliminate

the existing specifications and (ii) adopt a more flexible—but improved—ap-

proach, possibly incorporating some of the alternatives proposed in this or other

studies but certainly employing a performance-scorecard approach to aid in a

(presumably negotiated) positive outcome. Mutually agreed changes to the CTF

Agreements will require concurrence of the US Congress.

xviii

4. Establish a CTF Distribution Policy and Indicative Drawdown Levels: Given

the inability to ensure outcome-improving changes to the CTF agreements, it

would be prudent to set a provisional distribution policy operating (sub-optimally)

under COFA rules and juxtaposed with a mutually agreed improved distribution

policy not constrained by the faults of COFA rules. Stochastic projections under

each category would allow the affected parties to have ample time to prepare for

the likely fiscal resources for FY2024 and beyond. Indicative drawdown levels

would bring about a sense of urgency, clearly incentivize efforts to increase con-

tributions to the funds and incentivize efforts to achieve mutual agreement and US

Congressional approval of desirable amendments.

5. Establish a Perpetual Fund in Palau: In the case of the RoP, the Compact estab-

lished a sinking fund designed to provide resources for the duration of the Com-

pact, but with no guarantee of further distributions thereafter. This study has high-

lighted the lack of intergenerational equity and proposed that the RoP move to a

more fairly distributed approach through adopting the goal to supplement the CTF

sufficiently that it can sustainably provide a fixed perpetual real drawdown in

FY2025 and thereafter.

6. Establish a Home-Country Contribution Policy: The needed response to the po-

tential disruptions can be achieved through additional contributions to shore up

the respective CTFs. In the cases of the FSM and RMI, the current bonanza in

fishing-fee revenues provides a source of funds that can mitigate the anticipated

shortfalls. The simulations indicate that both nations can improve their respective

CTF performance such that they approach long-run sustainability with a high

level of confidence.

The simulations further indicate that sustainability can be achieved without modi-

fying the existing, flawed COFA framework and may be read as suggesting that

no change is required. However, the simulations are based on the assumption that

both nations commit resources at the level specified. This, of course, is far from

guaranteed. Under such uncertainty, reform of the COFA arrangements should re-

main a priority. In other words, regardless of actual FAS commitments of addi-

tional contributions, the CTFs can be amended to provide better outcomes.

In the case of the RoP, the option of implementing the tax-reform initiative has

been used to explore the degree of adjustment necessary to maintain financial sta-

bility. The RoP is fortunate to host a growing economy that will support adjust-

ment.

1

II. TRUST FUND DYNAMICS

1. INTRODUCTION

1. The original Compacts of Free Association (COFA) for the FSM and RMI for the

period FY1987–FY2003 did not contain any provisions for a trust fund. In the case of Pa-

lau, the original Compact (FY1995–FY2009) included provision for a COFA Trust Fund

with a contribution of $66 million in FY1995 and a further $4 million in the subsequent

year of FY1996, thus totaling $70 million. At the outset of the fifth year under the Com-

pact, Palau was entitled to draw down $5 million annually over the period FY1999–

FY2009, and thereafter a further $15 million annually during the remainder of the 50-

year Compact period through FY2044. The COFA Trust Fund was designed as a sinking

fund for the duration of the Compact based on an assumed 12.5 percent rate of growth.

While interest rates were above normal during the period in which the Palau Compact

was negotiated, this rate was clearly high by historical standards. The Palau fund was de-

signed to provide a guaranteed nominal distribution of $15 million until the projected ex-

haustion of the fund in FY2044.

2. In the cases of the FSM and RMI, the inclusion of trust funds arose during the ne-

gotiations of the amended Compact. Initially, a further 15-year period was conceived, but

it was quickly realized that given the financial resources available, this period was insuf-

ficient, and the term was extended to the existing 20-year period FY2004–FY2023. US

contributions and their allocation between the annual sector grants and contributions to

the trust fund are shown in Table 1. In the FSM, the contributions are fixed at $92 million

a year, but while the grants are subject to an annual decrement of $0.8 million, the contri-

bution to the trust fund rises by an equivalent amount. In the RMI, the same pattern is ob-

served: total contributions start at $57.7 million and rise by $5 million in FY2014 to

$62.7 million with an annual decrement of $0.5 million. In both countries, the annual

transfers and contributions are inflation adjusted by two-thirds of the US GDP deflator.

3. Returning to Palau, negotiations for renewal of the Compact were concluded in

September 2010 for a further 15-year period through FY2024. The passage of an omnibus

appropriation for the remaining period from March 24 to September 30, 2018, included

full passage of the funding required to fulfill the commitments of the Compact Review

Agreement. It appears funding will be available starting in FY2019. The funding sched-

ule, having been rendered moot by the delay, is to be revised through mutual agreement

of the parties, subject to the funds being made available starting at the outset of FY2019.

A key part of the negotiations that led to the Compact Review Agreement was the pro-

jected likely failure of the trust fund before the target date of FY2044. This, it was ar-

gued, was wholly a consequence of the overly optimistic assumption of 12.5 percent fund

returns adopted during the formulation of the original Compact. The structure of the re-

newed Compact arrangements was thus in part to provide additional resources to the fund

and to delay withdrawals at the full $15 million level. The major provisions under the re-

newed Compact arrangements are shown in Table 2. The anticipated revised schedule

2 Compact Trust Funds in the Freely Associated States

will account for funds provided on a stopgap basis from FY2010 to FY2018 and other-

wise revise the schedule and allocation of additional funding, perhaps with an accelera-

Table 1 US annual contributions to the FSM and RMI: sector grants and trust funds (US$ millions)

Year Annual GrantsTrust Fund

ContributionsTotal Annual Grants

Trust Fund

ContributionsTotal

FY04 76.0 16.0 92.0 50.7 7.0 57.7

FY05 76.0 16.0 92.0 50.2 7.5 57.7

FY06 76.0 16.0 92.0 49.7 8.0 57.7

FY07 75.2 16.8 92.0 49.2 8.5 57.7

FY08 74.4 17.6 92.0 48.7 9.0 57.7

FY09 73.6 18.4 92.0 48.2 9.5 57.7

FY10 72.8 19.2 92.0 47.7 10.0 57.7

FY11 72.0 20.0 92.0 47.2 10.5 57.7

FY12 71.2 20.8 92.0 46.7 11.0 57.7

FY13 70.4 21.6 92.0 46.2 11.5 57.7

FY14 69.6 22.4 92.0 50.7 12.0 62.7

FY15 68.8 23.2 92.0 50.2 12.5 62.7

FY16 68.0 24.0 92.0 49.7 13.0 62.7

FY17 67.2 24.8 92.0 49.2 13.5 62.7

FY18 66.4 25.6 92.0 48.7 14.0 62.7

FY19 65.6 26.4 92.0 48.2 14.5 62.7

FY20 64.8 27.2 92.0 47.7 15.0 62.7

FY21 64.0 28.0 92.0 47.2 15.5 62.7

FY22 63.2 28.8 92.0 46.7 16.0 62.7

FY23 62.4 29.6 92.0 46.2 16.5 62.7

FSM RMI

Trust Fund Dynamics 3

tion during the remaining six years from FY2019 to FY2023 (see chapter V for a re-esti-

mated schedule consistent with the March 2018 authorization and appropriation by the

US Congress).

2. THE STRUCTURE OF THE FSM AND RMI TRUST FUNDS

4. The FSM and RMI Compact Trust Funds are each composed of four accounts: the

A account, known as the corpus, a B holding account, a C stabilization, or buffer, ac-

count, and a D account that can accommodate additional, segregated contributions and

earnings under the control of the FSM or the RMI, respectively. In the initial accumula-

tion phase through FY2023, contributions are deposited into the A account and annual in-

vestment income above 6 percent in any year is transferred to the C account. The C ac-

count is capped at three times the projected annual sector-grant transfers in FY2023.

5. During the drawdown phase after FY2023, all income of the corpus will be trans-

ferred to the B account for distribution. Distributions are capped at the FY2023 sector-

grant level fully adjusted for inflation (US GDP deflator). If there are excess funds above

the annual projected distribution, these are transferred to the C account until the C ac-

count reaches its maximum value of three times the FY2023 nominal drawdown level

(unadjusted for inflation).

6. Once the cap of the C account has been reached, any excess is returned to the cor-

pus. If the B account has inadequate funds to meet the target distribution, these may be

topped up from the C account. If the sum of the B and C accounts is below the target or if

the C account has been exhausted, additional funds may not be withdrawn from the A ac-

count, resulting in a distribution shortfall. Hence the possibility of zero-distribution years.

Table 3 Annual US contributions to the RoP for budgetary support and trust fund, and permitted trust fund drawdowns

Trust Fund

Contribution

Trust Fund

DrawdownDirect Assistance

Total Funds for

government

operations

Infrastructure

Projects

FY2011 5.00 13.00 18.00 8.00

FY2012 5.00 12.75 17.75 8.00

FY2013 3.00 5.00 12.50 17.50 8.00

FY2014 3.00 5.25 12.00 17.25 6.00

FY2015 3.00 5.50 11.50 17.00 5.00

FY2016 3.00 6.75 10.00 16.75 5.00

FY2017 3.00 8.00 8.50 16.50

FY2018 3.00 9.00 7.25 16.25

FY2019 3.00 10.00 6.00 16.00

FY2020 3.00 10.50 5.00 15.50

FY2021 3.00 11.00 4.00 15.00

FY2022 3.00 12.00 3.00 15.00

FY2023 0.25 13.00 2.00 15.00

Table 2 Annual US contributions to the RoP for budgetary support and trust fund, and permitted trust fund drawdowns

Trust Fund

Contribution

Trust Fund

DrawdownDirect Assistance

Total Funds for

government

operations

Infrastructure

Projects

FY2011 5.00 13.00 18.00 8.00

FY2012 5.00 12.75 17.75 8.00

FY2013 3.00 5.00 12.50 17.50 8.00

FY2014 3.00 5.25 12.00 17.25 6.00

FY2015 3.00 5.50 11.50 17.00 5.00

FY2016 3.00 6.75 10.00 16.75 5.00

FY2017 3.00 8.00 8.50 16.50

FY2018 3.00 9.00 7.25 16.25

FY2019 3.00 10.00 6.00 16.00

FY2020 3.00 10.50 5.00 15.50

FY2021 3.00 11.00 4.00 15.00

FY2022 3.00 12.00 3.00 15.00

FY2023 0.25 13.00 2.00 15.00


7. A special account in the CTF, the D account, has been created for the RMI to de-

posit additional revenues and income. The RMI may draw on these funds for unantici-

pated shortfalls in distribution or other purposes. At the start of the amended Compact,

Taiwan agreed to deposit $10 million on behalf of the RMI into the D account.

8. The essential nature of the FSM and RMI trust funds is thus one where their de-

sign focused on protecting the nominal value of the corpus above all other considerations.

Of course, this objective may not be achieved if market returns in any year are negative.

Annual distributions may be made up to the maximum, but if resources are inadequate,

transfers for government operations will be cut or simply not made. The FSM and RMI

trust funds have thus been designed to favor future generations through protecting the

nominal value (although even this objective may not be achieved) at the expense of the

current generation.

3. THE STRUCTURE OF THE ROP TRUST FUND

9. Compared to the FSM and RMI, in Palau, the CTF, as part of the original Com-

pact, was designed very differently to be a sinking fund and to provide a fixed nominal

yield of $15 million until the corpus is exhausted. This implies the CTF is anticipated to

fail at some unspecified point in the future, and at that point a fiscal adjustment equiva-

lent to the $15 million will be required. The nature of the design of the existing arrange-

ments, unlike that in the FSM and RMI, is thus to pass on the entire loss and fiscal adjust-

ment of the $15 million to some future generation of Palauans.

4. TRUST FUND PRINCIPLES

10. In November 2002, the Economic Management and Policy Advisory Team (EM-

PAT) prepared a technical note on the pending amended Compact Trust Fund Agreement

for the FSM. While the note was written for the FSM, it remains relevant and applicable

to RMI and even to Palau. The note outlined two core principles the trust fund should

embody:

Principle 1. The real, inflation-adjusted value of the trust fund should be protected.

Principle 2. The trust fund should provide a secure and stable source of revenues to

the national and state governments of the FSM on an annual basis.

11. The note went on to point out that “sadly there is no way in theory or in practice

to achieve both of these core principles in full.” The note indicated that the trust fund

agreement had not been drafted in a way that protected the first principle or indeed the

second. In effect, only the nominal value of the corpus is protected as any income (de-

fined as the increase in corpus value at the end of the year over the opening balance) is

transferred to the B account for distribution. At the same time, if the funds in the B ac-

count are fewer than the previous year’s distribution and the C account is insufficient to


cover the shortfall, the corpus (A account) may not be accessed to make up for the short-

fall.1 Thus, in effect, only the corpus (A account) is protected against any reduction in

nominal value (that is, outside any loss in market value of the corpus, in which case the

nominal value of the A account would also decline). Further, the subsidiary agreement

simply fails to address any distribution shortfalls, implying the FSM or RMI would be re-

quired to make up the shortfall or make the necessary fiscal adjustments.

12. While the attempt to protect the corpus is indeed one of the two major objectives,

protection of the corpus at the expense of allowing for zero-distribution years indicates a

potential imbalance between the CTF principles. In essence, the current distribution

mechanism has been established to protect the corpus and implicitly future generations,

to the possible exclusion of the interests of current generations. The failure to achieve in-

tergenerational equity while allowing for potentially disruptive volatility in distribu-

tions—and still failing to protect the real value of the corpus over time—is indicative of a

seriously flawed mechanism. In the previously cited ADB study, author Michael

Wulfsohn described the difficulty posed when reviewing the CTF structure, saying, “Un-

fortunately, intuition is insufficient to analyze [the structure of the FSM and RMI Trust

Funds] and its implications in the face of investment volatility.” He concluded, consistent

with the US Government Accountability Office (GAO) and GSUSA, that sophisticated

modeling using Monte Carlo analysis is required in the analysis of the COFA structure

and rules to “reveal” both the most likely outcome (median results) and the range of po-

tential outcomes (including tail risks). Of course, these same methods can be applied to a

vast range of potential alternative methodologies. In fact, the GSUSA team has used its

model to test dozens of approaches and hundreds of variations of those modeled ap-

proaches.

13. Inherent in the current trust fund distribution formulation is that not only are zero

distributions probable but also large swings will occur in annual drawdowns from one pe-

riod to the next. The attempt to protect the corpus and future generations results in poten-

tially extreme volatility. It is thus proposed that a third trust fund principle be explicitly

stated to minimize distributional volatility:

Principle 3. Annual distributions should entail minimal volatility from period to

period, and when volatility is required it should be of known magni-

tude to limit disruption to the operations of fiscal policy.

14. In the case of Palau, the trust fund was designed as a sinking fund to provide an

identical nominal annual distribution to support government operations. However, the

fund was also designed to expire at some point in the future (targeted at the end of the 50-

year Compact period through FY2044), and thus implicitly favors current over future

1 Compact Trust Fund subsidiary agreement, Article 15.6 (Investment and Distribution to the

Government of FSM) and Article 16.6 (Investment and Distribution to the Government of

RMI).


generations. While principles 1 and 2 thus remain important, principle 3 concerning vola-

tility is redundant and dropped from the list. However, avoidance of fund collapse is criti-

cal, and for Palau in this analysis, principle 3 is replaced as follows:

Principle 3. The CTF should be protected against collapse of the corpus.

5. MARKET RISK

15. It is important at the outset to inspect the degree of risk investments are exposed

to in financial markets. Figure 1 indicates the annual total return of investments in the

S&P 500, US government T-bills and US government 10-year bonds. The S&P 500 index

displays large annual fluctuations during the period 1925–2017. US 10-year bonds dis-

play less volatility, or risk, while T-bills are more stable but of course accompany much

lower returns. On average, the S&P 500 returned 11.9 percent during this period while

the yield on the 10-year bonds averaged 5.5 percent. While the average, or mean, return

on the S&P 500 index looks favorable, the standard deviation, a measure of dispersion,

was 19.8 percent. This implies that two-thirds of the time, one could expect a return rang-

ing between −7.9 to 31.7 percent, a very large range of possible outcomes.

16. It is also important to note that the measure of the simple mean rate of return

overstates the geometric, or compound, mean rate of return. The geometric rate takes that

value of the S&P 500 in 2017 compared with 1925 and calculates the rate of return re-

quired to attain the 2017 value. The geometric mean on the S&P 500 during this period

Figure 1 Return on Investment in US Stocks and Bonds, 1925-2017

-60%

-40%

-20%

0%

20%

40%

60%

S&P 500 T-Bill 10 Year Gov Bonds


was 10.0 percent, some 1.9 percent less than the simple mean.1 One further needs to ac-

count for inflation, which during this period averaged 2.9 percent, implying that real re-

turns on the S&P 500 were 7.1 percent. After allowing for investment management fees

(fees of 50 basis points have been assumed in the present analysis), it can be said that an

average institutional investor could anticipate a long-run geometric-mean real rate of re-

turn of 6.6 percent. In the case of the Compact Trust Funds being investigated in this

study, the resources are invested in a balanced portfolio designed to reduce risk, and the

portfolio geometric-mean rate of return will be different from that of the S&P 500.

6. BENCHMARKS AND PERFORMANCE MEASURES

17. In this section, we define some useful benchmarks, performance measures and

time variables to aid the analysis:

7. Target Distribution: For the FSM and RMI, this is defined as per amended Com-

pact Trust Fund Agreement (Articles 16.7 and 15.7, respectively) as the FY2023

grant-assistance level plus full inflation adjustment thereafter.

In the case of Palau, this is defined as the annual $15 million permissible under

the Compact plus inflation adjustment. Switching to an inflation-adjusted level

would require US concurrence since annual distributions would, as soon as the

change is to be implemented, exceed $15 million.

8. Primary Target: The primary-target fund estimate is defined as the value of the

CTF required to yield the target distribution in a given year based on the econo-

metrically estimated real geometric portfolio rate of return. Since the primary tar-

get is based on a real (inflation-adjusted) rate of return, it also implicitly provides

for reinvestment of earnings necessary to maintain the real value of the fund. This

measure of the fund is a benchmark that assumes no market risk. In itself, it is not

a measure of fund sustainability since it ignores risk, but nevertheless it provides a

useful benchmark.

9. Sustainability Adjustor: The sustainability adjustor is the empirically estimated

percentage above the primary target that the CTF should attain to accommodate

an “acceptable” degree of market risk. This is elaborated below.

10. Sustainability Target: This is defined as the primary target multiplied by the sum

of one and the sustainability adjustor.

11. Initial Year: For the FSM and RMI, this is FY2024, and for Palau it is FY2025.

12. Terminal Year: For the FSM and RMI, this is FY2050, and for Palau it is

FY2044, the final year of the Palau Compact.

1 A further improvement can be made through estimating the geometric mean econometrically

rather than using end points as in the above explanation.


13. Accumulation Period: For the FSM and RMI, this is the period FY2018–FY2023,

and in the case of Palau, FY2018–FY2024. In the Palau case, funds are also being

withdrawn during this period, but at a rate that allows the fund to accumulate in

years of normal market returns.

14. Drawdown Period: This is the FY2024–FY2050 period for the FSM and RMI and

FY2025–FY2044 for Palau.

18. Performance of the CTF is assessed against a series of benchmarks related to the

three CTF principles outlined above. The simulations are conducted over the respective

distribution periods. Each of the core principles has two elements: (i) an average over the

drawdown periods, and (ii) a value in the respective terminal years. The focus is thus on

both averages over the drawdown periods and steady-state values measured in the termi-

nal year. In the context of Monte Carlo analysis with 10,000 cases being run, this results

in (i) an average of the observed median value for each of 10,000 cases, and (ii) an aver-

age for the terminal value for each of the 10,000 cases. The benchmarks are designed to

achieve intergenerational equity.

1. Protecting the Corpus:

a. Probability that the terminal real value of the CTF is above the initial-year

value

b. Probability of attaining or exceeding the primary target in the terminal

year

2. Protecting Distributions:

a. Average distribution through drawdown period as a percentage of the tar-

get distribution

b. Probability of attaining or exceeding the target distribution in the terminal

year

3. Protecting against Volatility:

a. Probability of a zero distribution in the drawdown period

b. Average number of years with reductions from the prior year in real distri-

butions

4. Performance Indicator: The performance indicator is an average of the above

three main categories with each submeasure accorded equal weighting. In the case

of the volatility estimates, the scores are one minus the indicator. Clearly, the

choice of the chosen performance measures is subjective, but those selected are

considered fair indicators of the core CTF principles.

5. Sustainability: The outcome of any set of simulations that attains a 95 percent

performance level is considered sustainable. It will be apparent that setting a


lower sustainability target, say 90 percent, would imply reduced caution but in-

creased median levels of distributions from the CTF—a classic tradeoff.

19. In the case of the RoP, the trust fund principle of minimizing volatility was re-

placed by the principle of protecting against collapse of the fund. To reflect this change,

the performance measure relating to volatility (number 3 above) is replaced with the fol-

lowing:

3. Protecting against Fund Collapse:

a. Probability of fund collapse before or in FY2044

In the scoring rules of the overall performance indicator, target 3 was measured as one

minus the indicator and accorded equal weight to the other two measures of protecting

the corpus and distributions.

7. TRUST FUND SIMULATIONS

20. The analysis undertaken in this study follows that in two other recent studies of

the amended Compact Trust Funds in the FSM and RMI by the US GAO1 and by the

ADB.2 Both studies deploy Monte Carlo simulation analysis to investigate the likely per-

formance of the two trust funds and their capacity to meet their objectives. The analysis

followed here does not depart from this approach. The simulations are based on a simple

portfolio composed of equities and bonds. Equities are composed of the S&P 500 (35

percent), a global equities index (25 percent), and emerging markets (5 percent). Bonds

are composed of US government bonds (15 percent), US corporate bonds (10 percent)

and world government bonds (10 percent). All indices are total-return indices including

reinvestment of interest and dividends. Data cover the historical period 1925–2017.3

Since the inflationary environment projected over FY2013–FY2050 is expected to be

lower than the historical series, the simulations have been run in real terms with inflation-

ary expectations added. The inflationary factor is the US GDP deflator, and the simula-

tions adopt the projections made by the US Congressional Budget Office. Further details

on the technical aspects of the simulation are provided in appendix 1.

21. The simulations start in FY2018 based on the value of the respective CTFs at the

end of FY2017. In the case of the RMI, the simulations include contributions from Tai-

wan to the A account but exclude contributions to the D account, which are discretionary

funds that can be withdrawn by the RMI. The simulations are split into two periods: the

accumulation phase and the drawdown phase thereafter.

1 See US Government Accounting Office, Trust Funds for the Micronesian and the Marshall

Islands May Not Provide Sustainable Income, GAO-07-513, June 2007, Washington, DC. 2 Asian Development Bank, Trust Funds and Fiscal Risks in the Federated States of Microne-


Aid Relationship, 2015, Manila. 3 See http://www.globalfinancialdata.com, Global Financial Data, San Juan Capistrano, CA.

http://www.globalfinancialdata.com/


22. The results of the following analysis do not deviate from those of the prior stud-

ies, and they reinforce the expectation that in the case of the FSM and RMI, the CTFs

will be underfunded and distribution shortfalls will be frequent if operating under existing

COFA rules. However, this study investigates alternate rules designed to provide a less

volatile pattern of distributions to minimize the adverse impact on fiscal management. It

also investigates alternative possibilities for increasing contributions to the funds. Three

alternative distribution rules are investigated: (i) the moving adjustment rule (MAR), (ii)

the sustainability rule (SR), and (iii) the sustainability adjustment for enhanced reliability

(SAFER) rule. In all cases, it is assumed the existing distribution mechanisms are dis-

pensed with, which can only occur in the wake of action by the US Congress.

8. MOVING ADJUSTMENT RULE (MAR)

23. In the MAR case, it is assumed a downward adjustment, or decrement, of 5 per-

cent of the previous year’s distribution will be made if a three-year moving average of the

CTF value falls below the primary target. Downward adjustment continues until the re-

duction in distribution exceeds the CTF shortfall (the ratio of the actual CTF value to the

primary target). At this point, an upward adjustment, or increment, of 2 percent is made.

Adjustment is thus asymmetric: on the downside, adjustment is more rapid, and on the

upswing, adjustment is slower in order to allow the CTF to return more rapidly to the pri-

mary target. This asymmetric approach has proven to produce better results as measured

by the performance indicators. On the upside, when the three-year moving average of the

CTF value exceeds the primary target there is no allowance for venting. However, some

adjustments to the CTF may be desirable in the event that the fund grows very large.

9. THE SUSTAINABILITY RULE (SR)

24. In this section, we examine what size of fund is likely to achieve sustainability

and generate a score of over 95 percent on the performance indicator. This problem can

also be viewed from the perspective of what level of drawdown can be sustainably

achieved without jeopardizing the three core principles outlined above. In the process, a

further alternative to the COFA and MAR rules is defined: the sustainability rule (SR).

i Defining Sustainable CTF Levels

25. To define a sustainable CTF level, the primary-target indicator is used as the

benchmark. Simulations are run assuming the CTF is funded at the primary-target level in

FY2024. Recall that the primary target is derived through dividing the target distribution

by the estimated real portfolio geometric rate of return. Simulations were run assuming

CTF levels ranging from 10 to 200 percent of the primary target in FY2024 in increments

of 10 percent.

26. Figure 2 provides the results of the simulations. Clearly, as the level of CTF fund-

ing increases, the score of the performance indicator improves. However, as the funding

level increases above about 50 percent of the primary target, decreasing returns to addi-


tional funding sets in and the benefit of additional funding declines. While it is not possi-

ble to unambiguously specify an optimal target level of performance, a 95 percent target

has been adopted. This translates into a funding level of the CTF (the sustainability tar-

get) of 67 percent (the sustainability adjustor) above the primary target. At this level, the

CTF corpus and annual distributions are maintained at healthy levels and volatility is re-

duced to a minimum. At the 95 percent level, a strong level of confidence can be assured

that the CTF will be sustainable in the long run.

ii The Sustainability Rule (SR)

27. The sustainability rule is based on the assumption that the realized CTF in the ini-

tial year of the drawdown period can be viewed as 67 percent above a newly defined SR

primary target. SR distributions are based on multiplying the estimated real geometric

portfolio yield by the SR primary target. The SR target distribution is thus 1/(1+sustaina-

bility adjustor) times the estimated real geometric portfolio rate of return times the real-

ized CTF value at the end of the accumulation period.

1. Sustainability Rule (SR) Primary Target: the realized CTF value at the end of the

accumulation period divided by 1 plus the sustainability adjustor

2. Sustainability Rule (SR) Target Distribution: the SR primary target times the

portfolio real geometric-mean return

Figure 2 Overall CTF Performance at different levels of funding relative to the Primary Target

0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

60.0%

70.0%

80.0%

90.0%

100.0%


10. THE SUSTAINABILITY ADJUSTMENT FOR ENHANCED RELIABILITY RULE

(SAFER)

28. The sustainability adjustment for enhanced reliability, or SAFER, rule is com-

posed of two parts: (i) a drawdown level sufficient to ensure the long-run sustainability of

the corpus with a high degree of confidence, and (ii) two measures for adjustment at the

tail ends of the distribution. The first part is attained through adoption of the SR rule. Tail

risk is considered in two parts: the downside and upside. For the downside risk, MAR is

applied to protect against adverse periods of market returns once the CTF value falls be-

low the SR primary target. On the upside, allowance is made for increases in distributions

once the CTF attains a certain safe threshold above the SR primary target. A threshold of

twice the SR primary target is set in the simulations; increases in annual distributions of 5

percent are allowed as long as the CTF remains above this level. Distributions are al-

lowed to rise until they reach the level agreed in the original Compact: the inflation-ad-

justed level of the FY2023 distribution. Table 4 provides a summary of the three adjust-

ment rules.


Table 4 Summary of the moving adjustment rule, sustainability rule, and SAFER rule

Rule Description Specification

Moving Adjust-ment Rule (MAR)

The MAR allows for distributions to reflect CTF performance. Dur-ing periods when the CTF corpus is below target, distributions may be adjusted downward to bring them in line with the sustainability of the corpus.

To support fiscal stability, adjust-ments are made in small but man-ageable decrements or incre-ments: 5 percent on the downside and 2 percent as CTF perfor-mance improves.

Distributions are modified depending on the ratio between the CTF value divided by the primary target and last year’s dis-tribution divided by the target distribu-tion.

If this ratio is less than 1, this year’s dis-tribution is cut by 5 percent. On the up-side, distributions are increased by 2 percent if the ratio is greater than 1.

In the initial year, if the ratio is negative, distributions may be cut up to 15 per-cent. Distributions are not allowed to rise above the target distribution.

Sustainability Rule (SR)

Distributions are set at the end of the accumulation period depend-ent on the level of CTF attained and that can be relied upon to yield a continuous flow of real re-sources with a high degree of confidence.

In most cases this will imply a sig-nificant negative fiscal adjustment in FY2023.

In the initial year of drawdowns, distribu-tions are set at the CTF value times the long-run estimated real geometric mean of the portfolio divided by the sum of one and the sustainability adjustor. This is defined as the SR primary target.

Distributions in subsequent years are fully indexed to the US GDP deflator.

SAFER Rule The SAFER rule combines the security of SR with adjustments for tail risk.

On the downside the MAR is adopted once the CTF falls below the SR primary target to sustain CTF levels during periods of weak market performance.

On the upside distributions are al-lowed to rise once the CTF rises above twice the SR primary target and they attain the target distribu-tion.

The SAFER rule is a combination of SR and tail-risk management.

On the downside, a downward adjust-ment of 5 percent per annum kicks in once the CTF value dips below the SR primary target.

On the upside, the distributions increase by 5 percent per annum once the CTF exceeds twice the SR primary target. Upward adjustment ceases once the target distribution is attained.

14

III. THE FSM COMPACT TRUST FUND

A. Performance of the Compact Trust Fund (FY2004–FY2017 and Projected through FY2023)

1. BACKGROUND

29. The establishment of the Trust Fund for the People of the FSM (CTF) was a ma-

jor feature of the amended Compact. The trust fund was created, according to the preface

of the CTF Agreement, “to contribute to the long-term budgetary self-reliance of the

FSM… [and] to provide the Government of the FSM with an ongoing source of revenue

after FY2023.” The design features of the trust fund related to distributions to the FSM

from FY2024 and thereafter are specified in the CTF Agreement, Articles 16(7) (a) and

(b). The explicit linkage of distributions and the fully inflation-adjusted value of the

Compact annual grant assistance provided in FY2023—notionally providing a smooth

transition—has the potential to create expectations that such levels of support from the

CTF may be forthcoming. However, the US government has made it clear that neither the

terms of the amended Compact nor the terms of the CTF Agreement make any guarantee

that the trust fund will be able to sustainably achieve distributions of any specific size.

30. Still, even the US Government Accountability Office (GAO) in its June 2007 re-

port1 completed its analysis based on the assumption that distributions would equal the

above-described (maximum) level. When challenged on that assumption with the fact that

such levels of disbursement are neither required nor guaranteed, the GAO countered that

“[they] believe it is appropriate to undertake a projection of the likely disbursements

against that benchmark.”2 The GAO also noted that “[they] believe that careful analysis

of the trust funds each year will help establish realistic expectations.”3

31. This chapter of this study is prepared in fulfillment of the GSUSA’s general terms

of reference to describe key economic trends and describe policy options for considera-

tion by our readers, especially FSM leaders and officials from the US and the FSM en-

gaged in Compact management. Given the immense importance of the CTF to the FSM’s

long-term prospects for achieving economic self-reliance, our study provides an analyti-

cal perspective in addition to that provided through the published reports of the FSM CTF

Committee, the US GAO and the ADB. The authors use the maximum level of distribu-

tion to complete probability-based (stochastic) projections for the period after FY2023,

while noting fully the risk of falling short and the need for FSM leaders to continue to

1. US Government Accounting Office, Trust Funds for the Micronesian and the Marshall Is-

lands May Not Provide Sustainable Income, GAO-07-513, June 2007, Washington, DC,

http://www.gao.gov/cgi-bin/getrpt/GAO-07-513. 2 Ibid, Appendix V, p. 56. 3 Ibid, Appendix V, p. 56.

The FSM Compact Trust Fund 15

strengthen their policy focus on alternative measures to mitigate the risk of potential peri-

odic (or even sustained) fiscal shocks.

32. As noted in previous GSUSA annual economic reviews, the CTF Agreement in-

cludes certain technical characteristics likely to become problematic during the distribu-

tion period. It is inarguable that the best interest of all parties would be served if, over the

long term, the real value of the CTF were protected and robust mechanisms ensured the

relative stability of annual distributions from the CTF to the FSM. Unfortunately, as cur-

rently specified, and in the absence of stellar investment return rates or large additional

contributions over the remaining accumulation period, the real value of the CTF corpus

has a high likelihood (76 percent probability) of declining over the course of the distribu-

tion period; perhaps more urgently, the stability of annual distributions will be at risk. Im-

mense and repeated fiscal shocks are more likely to arise because of the specific charac-

teristics agreed to by the parties and enacted in US law. The result is a high likelihood (72

percent probability) of at least one fiscal year in which zero distribution would be al-

lowed under prevailing rules. While amending these provisions is no easy task—espe-

cially since US Congressional approval is required—the FSM CTF Committee, in collab-

oration with JEMCO and with the US and FSM governments, may wish to consider (a)

modifying problematic design characteristics of the buffer-account mechanism, (b) modi-

fying the distribution mechanism that results in timing that conflicts with the prevailing

practice of estimating annual allocation decisions each January and confirming those de-

cisions each August in advance of the subject fiscal year, and (c) devising distribution

rules that could better protect the real value of the corpus over the long run while also re-

ducing the volatility of distribution levels and reducing the frequency of shortfalls in an-

nual fiscal support to the FSM.

2. PERFORMANCE MONITORING

33. This subsection presents a CTF simple sufficiency estimate and related analysis.

That estimate is defined as the size the CTF would need to achieve by the end of FY2023

to support a smooth and sustainable transition from US-appropriated annual sector grants

to fully inflation-adjusted annual CTF distributions to the FSM. The simple sufficiency

estimate is updated to reflect actual outcomes to date, particularly with respect to the par-

tial inflation adjustment that has been applied through the FY2019 budget estimates and

to projected inflation going forward. Future inflation projections are linked to US Con-

gressional Budget Office published projections through FY2025.1 Using these assump-

tions, the level of Compact sector grants in FY2023 is projected at $80.8 million. With

full projected inflation (at 2.05 percent) for FY2024, the $80.8 million is adjusted upward

to $82.5 million.

34. It is assumed that the FSM CTF investment strategy at that time would need to

provide for a prudent balance of risk while allowing for long-term growth. From FY2024

1 http//:www.cbo.gov/publication/45066, Economic Data and Projections, January 26, 2015,

Table A-3, prices (fiscal years)

http://www.cbo.gov/publication/45066


onward, and for estimation purposes only, a balanced investment allocation is assumed,

as detailed in the following section of this chapter. Over a 92-year period, the real rate of

return using econometric estimation techniques is 5.0 percent. Thus, if inflation were to

average 2 percent, a nominal rate of return of 7 percent is implied. Dividing the $82.5

million (maximum) distribution by a 5.0 percent real rate of return yields a simple suffi-

ciency target of $1.66 billion.

35. Using the above-detailed assumptions, and starting with the end-of-FY2017 FSM

CTF value of $563,783,927, the rate of return required to achieve the simple sufficiency

estimate for the FSM CTF of $1.66 billion would be 15.1 percent annually for the six re-

maining years through FY2023. Such a sustained rate of growth is extraordinarily un-

likely to be achieved. Using probability analysis, the median projected level of the FSM

CTF at the end of FY2023 is $1.14 billion, or 69 percent of the simple sufficiency esti-

mate.

36. To put those forward projections into perspective, the long-term projected rate of

return of 7.0 percent in nominal terms moderately exceeds the rate of return experienced

by the FSM CTF during the period it has been invested, FY2007–FY2017. The experi-

enced asset-weighted rate of return during that same period has been 6.87 percent. The

asset-weighted rate of return from initial funding on October 1, 2004, through the end of

FY2017 is 6.75 percent, reflecting the delay in getting the CTF established and fully in-

vested at the outset of the amended Compact period.

37. The FSM has not funded the D account within the CTF mechanism. However, the

FSM has its own trust fund that may be used after FY2023 to support fiscal stability. The

purpose of the FSM Trust Fund was previously unspecified but has now been specified in

a manner that may be more conservative and inflexible than the CTF. The primary objec-

tive is now clearly indicated as addressing post-FY2023 fiscal-stability concerns. As of

the end of FY2017, the value of that account is estimated at $82.6 million. That amount is

just less than 15 percent of the size of the FSM CTF (A plus C accounts) at the same date.

Looking forward, the projections in the section below indicate that the FSM Trust Fund

could, at median-level outcomes, add $260 million to the projected CTF value of $1.14

billion, representing a 23 percent increase. The achievement relative to the primary target

of $1.66 billion would be increased from 69 percent to 85 percent. To the extent the FSM

continues to dedicate significant portions of its (national-government) structural surplus,

the FSM Trust Fund could grow to become an important supplemental funding source to

mitigate periodic or sustained fiscal shocks. To provide that benefit, it is likely the rules

of the FSM Trust Fund would need to be revised to serve as a better complement to what-

ever CTF rules are being utilized after FY2023.

38. Consistent with recommendations in recent CTF annual reports, joint or unilateral

efforts to mobilize additional contributions—from domestic and external sources—to the


CTF would improve the FSM’s long-term fiscal stability and economic security. Simi-

larly, the FSM national government’s apparent ongoing commitments to aggressively ad-

dress post-FY2023 fiscal risks are both prudent and promising.

39. It should be noted that achieving a CTF size that matches the simple sufficiency

estimate—as unlikely as that is for the FSM CTF—does not, by any means, eliminate the

risks going forward of subsequent severe and repeated fiscal shocks. Periodic strong per-

formance of the CTF does not eliminate the urgency to consider opportunities to achieve

mutual agreement on a distribution policy or amendments to enhance the CTF agreement.

In the following subsection, a more sophisticated, risk-inclusive form of analysis is pre-

sented to analyze the range of outcomes that might prevail given the volatility of market

returns and the uncertainty of the sequence of those returns over time. That analysis de-

fines a SAFER alternative that, in effect, requires a larger fund balance than the “simple

sustainability” estimate. As shown in Figure 3, that estimate is for a fund size of $2.76

billion. In essence, to manage the degree of volatility inherent to the asset mix consid-

ered, the primary target needs to be increased by a factor of 1.67.

40. A range of factors have combined to result in a CTF value that is now substan-

tially below the projected path to achieve the simple sufficiency estimate by the end of

FY2023. The most important factor is the investment climate that has prevailed from

FY2004 through FY2015. Addressing other factors, the authors provided a lengthy dis-

cussion on delays in establishment of the FSM CTF and further delays in implementing

an investment strategy (see the FY2011 report at http://www.econmap.org).

Figure 3 Projected FSM Compact Trust Fund Value through FY2023

http://www.econmap.org/


B. Simulating the CTF under the COFA Rules

1. TRUST FUND PERFORMANCE

41. This section is forward looking and simulates performance and ability to achieve

the CTF principles outlined in chapter II over the remaining accumulation and drawdown

period. The simulations use Monte Carlo analysis. The method is described in more detail

in appendix 1. Figure 4 provides a depiction of the simulated CTF value at the end of

FY2023 before drawdowns commence. It indicates that from a value of $564 million at

the end of FY2016, the fund is likely to attain a value of $1,139 million in FY2023 (the

median simulated value). However, the probability of the CTF attaining the level of the

primary target is just 7 percent. Further, it must be borne in mind that the primary target

is only a benchmark and is based on a risk-free assumption. Figure 4 thus indicates that

the likely level of the CTF in FY2023 will be very significantly below a level required to

provide a reliable yield to support government operations in the FSM thereafter.

42. Table 4 provides statistics based on the performance criteria defined above for the

set of simulations undertaken in this study. Focusing on the results for the COFA simula-

tions and the measure for protecting the corpus, the probability of maintaining the real

Figure 4 Probability Distribution of FSM Compact Trust Fund in FY2023

Median expected value = $1,139

Primary-target estimate = $1,655 million 7% chance of attainment


value of the corpus between FY2023 and FY2050 is low, at 24 percent, but an improve-

ment over the probability of attaining the primary target in FY2023 of 7 percent. The

probability of the CTF being above the primary-target value in FY2050 is also small,

only 19 percent.

43. The second section of Table 4 further indicates the nature of the annual distribu-

tions that can be anticipated after FY2023. In terms of supporting the target drawdown,

the average distribution throughout the period is larger, at 75 percent, while the probabil-

ity of attaining the target in FY2050 is only 39 percent. In terms of volatility, the proba-

bility of experiencing a zero distribution in the FY2024–FY2050 period is a very large 72

percent, while the percentage of years with downward adjustment in the real value of dis-

tributions is 30 percent, or an average of four years. These results bring out the volatile

nature of the COFA rules: there is a tendency to the extremes of either meeting the target,

which is reflected in a high average drawdown of 75 percent, or failing entirely, which is

reflected in the high probability of experiencing at least one zero distribution. Finally, the

overall performance rating of the CTF under the COFA distribution mechanism is 43 per-

cent. On its own, this benchmark has little value without comparison to the alternative

simulations, discussed below. These results confirm the previous studies showing that the

projected CTF distributions under the COFA rules will be highly volatile and fail to sup-

port fiscal stability and the operational needs of the FSM national and state governments.

Table 5 FSM Compact Trust Fund simulated results and performance

Simulations

Performance Measures COFA Rules

Moving

Adjustment

Rule

Sustainability

RuleSAFER Rule

Compact Trust Fund Corpus results

Probability of real CTF in FY50 > the FY23 value 24.3% 51.8% 82.2% 80.2%

Probability of real CTF value > the Primary Target in FY50 19.4% 34.9% 68.9% 61.7%

Distribution results

Average distribution through FY24-FY50 % target 75.1% 67.3% 43.5% 56.9%

Proabability of attaining target distribution in FY50 39.2% 21.1% 0.1% 37.2%

Volatitity results

Probability of a zero distribution between FY24 to FY50 71.9% 6.0% 0.4% 0.0%

Distribution % prior year counted for reduction years only 29.8% 6.0% 4.1% 4.7%

Overall performance rating 42.7% 60.5% 65.0% 71.9%

Rule Sets


2. VOLATILITY

44. Figure 5 provides some more information on the volatility of the changes in an-

nual drawdowns. The figure indicates the number of cases, or probabilities, of distribu-

tions falling in each of the ranges indicated selected at five yearly intervals. For example,

at the start of the amended Compact in FY2025, in nearly all cases, over 90 percent of

them, distributions reach the maximum of $82.5 million. It is rare to have a case with

less-than-full distributions. By the time we get to FY2035, the situation has deteriorated

and only in 63 percent of cases are distributions at the maximum, with 10 percent now re-

cording zero distributions. By the time we get to FY2050, the number of full distributions

has dropped to 40 percent, with the number of zero distributions rising to 15 percent. The

graph indicates that the COFA rules favor distributions that are large but declining over

time with a growing number of zero distributions. Clearly, stable fiscal management can-

not be sustained in such an environment.

45. The volatility of the CTF mechanism is also well established through examination

of the results of individual simulations. The Monte Carlo analysis adopted in this study

follows a standard approach of running 10,000 simulations to derive the statistics pre-

sented. In Figure 6, five simulations have been selected at random.1 Of the 10,000 simu-

lations, the 5th, 7th, 9th, 14th and 16th simulations out of the first 20 were selected using

1 Figure 6 is based on a similar diagram presented in the ADB study, which vividly displays

the inadequacies of the amended Compact distribution mechanism.

Figure 5 Distributions by number of cases falling in selected ranges under COFA rules

-

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

10,000

FY25 FY30 FY35 FY40 FY45 FY50


$0m

$20m

$40m

$60m

$80m

$100m

$120m

$140m

$160m

$180m

$0.0b

$0.5b

$1.0b

$1.5b

$2.0b

$2.5b

$3.0b

"A" account after distributn "C" account after distributnTarget Distribution Distribution

$0m

$20m

$40m

$60m

$80m

$100m

$120m

$140m

$160m

$180m

$0.0b

$0.5b

$1.0b

$1.5b

$2.0b

$2.5b

$3.0b


Sim 7

$0m

$20m

$40m

$60m

$80m

$100m

$120m

$140m

$160m

$180m

$0.0b

$0.5b

$1.0b

$1.5b

$2.0b

$2.5b

$3.0b


Sim 9

Average rate of return 8.8% Geometric rate 8.5%



Sim 5


Microsoft Excel’s random-number generator. While the simulations represent only a lim-

ited sample, they provide a good indicator of what can be expected. Simulation 5 indi-

cates a generally favorable result, with the geometric rate of return of 8.5 percent slightly

less than the benchmark of 8.6 percent. Distributions reach the target in all years with the

exception of FY2035, when there is a massive fiscal shock and a 44 percent reduction in

funding. The results of this simulation indicate that despite a well-funded CTF that grows

through much of the period, the COFA rules will generate large disruptive reductions in

distributions.

$0m

$20m

$40m

$60m

$80m

$100m

$120m

$140m

$160m

$180m

$0.0b

$0.5b

$1.0b

$1.5b

$2.0b

$2.5b

$3.0b


Sim 14Average rate of return 6.8% Geometric rate 6.0%

Average rate of return 7.4% Geometric rate 6.5

Figure 6 Randomly selected CTF trajectories and drawdowns FY2024-

FY2050

$0m

$20m

$40m

$60m

$80m

$100m

$120m

$140m

$160m

$180m

$0.0b

$0.5b

$1.0b

$1.5b

$2.0b

$2.5b

$3.0b


Sim 16



46. Market returns in simulation 7 are below average, at 5.8 percent, and the CTF

fails to grow, declining through the period. The fund manages to generate maximum dis-

tributions until FY2037, when a reduction of 14 percent occurs. By FY2046, after years

of weak performance, the C account is finally depleted and a massive fiscal shock of 69

percent results, with distributions dropping to zero in the following year. In FY2048, dis-

tributions recover, but they collapse again in the following year. The results for simula-

tion 9 are somewhat similar, although market returns are close to average and the fund

grows over time. There are four reductions in distributions, one of which is a zero distri-

bution. Simulations 14 and 16 are similar, with weak market returns and wild oscillations

in distributions. In simulation 14, there are seven zero-distribution years, and in simula-

tion 16 there are five. In simulation 14, performance is terrible throughout the period, and

it deteriorates through time. In simulation 16, the worst is bunched toward the end of the

period. These results are examples of the distribution functions shown in Figure 5, with

deteriorating performance over time.

C. Moving Adjustment Rule (MAR)

47. In this section, an alternative rule is specified deliberately designed to smooth the

volatility of the COFA rules, but done through removing the A and C account mecha-

nisms. Under this rule, known as the moving adjustment rule (MAR), distributions are

made directly from the remaining CTF. In the MAR case, it is assumed a downward ad-

justment, or decrement, of 5 percent of the previous year’s distribution will be made if a

three-year moving average of the CTF value falls below the primary target. Downward

adjustment continues until the reduction in distribution exceeds the CTF shortfall (the ra-

tio of the actual CTF value to the primary target). At this point, an upward adjustment, or

increment, of 2 percent is made. Adjustment is thus asymmetric: on the downside, adjust-

ment is more aggressive, and on the upswing, adjustment is slower in order to allow the

CTF to return more rapidly to the primary target. All distributions are made directly from

the CTF, and there is no buffer account. On the upside, when the CTF value exceeds the

primary target, no allowance has been included for venting. Under the existing financial

circumstances of the FSM CTF, such an event is highly unlikely. However, some adjust-

ments to the CTF may be desirable in the unlikely circumstance that the fund grows very

large.


48. Referring back to Table 4, the basic metrics for the MAR simulations are pro-

vided. The starting position is the same as under the COFA case and the value of the CTF

only attains the primary-target value in 7 percent of cases. However, in terms of sustain-

ing the CTF corpus, the results in FY2050 are improved significantly: the CTF is above

the real FY2023 simulated value in 52 percent of cases (vs. 24 percent under COFA

rules), and attains 35 percent of the primary-target value (vs. 19 percent under COFA

rules). In essence, better results are achieved through adopting a responsive distribution

mechanism. The annual decrement of 5 percent over time allows the CTF corpus to re-

cover. However, in some cases the situation is so adverse that the CTF cannot regenerate,


and in 6 percent of cases the fund collapses, leaving no resources to generate income for

future generations.

49. In terms of average drawdown over the period, MAR scores 67 percent and is out-

performed by COFA, which scores 75 percent. In terms of achieving the target distribu-

tion in FY2050, the probability falls from 39 percent under the COFA rules to 21 percent

under MAR. In effect, the annual adjustment under MAR reduces the level of the annual

drawdown to sustain the level of the corpus in the long run. In terms of volatility, there is

a significant improvement, with the probability of a zero distribution during the draw-

down phase falling from 72 percent to 6 percent. Similarly, the probability of a negative

reduction in distribution falls under MAR (from 30 percent to 6 percent).

2. VOLATILITY

50. Figure 7 (the comparison to Figure 5) presents the number of cases, or probability

distribution, of drawdowns falling in selected five yearly intervals. In FY2025, the vast

majority of cases—7,453 (i.e., 75 percent)—produce a distribution in the $57 to $65 mil-

lion range. There are few distributions below this range, but there are some that exceed it.

For FY2030, in 4,024 cases, distributions fall in the $41 to $57 million range with, again,

few below but some above. As time progresses, the largest number of cases fall in lower

ranges and in decreasing numbers. The number of zero distributions also increases with

time, and the adjustment mechanism is unable to ward off eventual fund collapse. On the

upside, as time progresses, the number of distributions falling in the target range (right

Figure 7 Distributions by number of cases falling in selected ranges under MAR rules

-

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

10,000



side of Figure 7) increases, indicating that with good market returns the MAR mechanism

allows the CTF to grow sufficiently to enable maximum distributions.

51. Figure 8 provides two simulations chosen to indicate a typical path of the CTF

value, target drawdowns, and actual drawdowns. The exercise is intended to reveal the

smooth path under MAR despite the need for adjustment. In the first simulation, the CTF

is well funded but below the primary-target value in FY2023. A downward adjustment in

annual drawdown is thus required to a level that persists over a number of years until a

period of better returns is encountered. Over the following years, the trust fund rises, as

do the annual distributions, as returns improve. By the end of the period, distributions are

converging on the target. In the case of simulation 2, the CTF value in FY2024 is close to

the median value but market returns during the distribution period are below historical

$0m

$20m

$40m

$60m

$80m

$100m

$120m

$140m

$160m

$0.0b

$0.5b

$1.0b

$1.5b

$2.0b

$2.5b

$3.0bCTF Value Target Distribution Distribution

Sim 1

Figure 8 selected CTF trajectories and drawdowns under the MAR Rule, Sim-

ulations 1 & 2, FY2024-FY2050

$0m

$20m

$40m

$60m

$80m

$100m

$120m

$140m

$160m

$0.0b

$0.5b

$1.0b

$1.5b

$2.0b

$2.5b


Sim 2

Average rate of return 9.0 Geometric rate of return 8.0

Average rate of return 7.2 Geometric rate of return 6.8


patterns. The annual path of distributions despite incurring significant adjustment is rela-

tively smooth and does not display the wildly oscillating permutations of the COFA rules.

The MAR rules have been designed to generate a smooth adjustment path, with known

decrements or increments, that responds to the funding status of the CTF. The principle

has been to design a rule that reduces the impact on the operation of fiscal management.

Clearly, MAR performs well in reducing volatility from one year to the next. It also per-

forms well in sustaining the level of the fund corpus, with a significant increase over the

COFA rule, although there remains a significant probability of collapse. However, it per-

forms less well in terms of average distribution size. The design of MAR to reduce vola-

tility and support the fund corpus over the long term is achieved through reductions in an-

nual drawdowns. Overall, MAR attains 61 percent on the performance indicator com-

pared with the 46 percent under COFA. However, while the results under the MAR case

are superior, they cannot be considered satisfactory. The score is well below the sustaina-

bility target of 95 percent, and significant fiscal adjustment that would undermine finan-

cial stability is imposed on the FSM.

D. The Sustainability Adjustment for Enhanced Reliability (SAFER) Rule

52. In this section, we simulate the performance of the sustainability adjustment for

enhanced reliability (SAFER) rule that was introduced in chapter II.1 The SAFER rule is

composed of two parts: (i) a drawdown level sufficient to ensure the long-run sustainabil-

ity of the corpus with a high degree of confidence, and (ii) two measures for adjustment

at the tail ends of the distribution. The first part is attained through adoption of a sustaina-

bility rule (SR). Tail risk is considered in two parts: the downside and upside. For the

downside risk, MAR is applied to protect against adverse periods of market returns once

the CTF value falls below the SR primary target. On the upside, allowance is made for

increases in distributions once the CTF attains a certain safe threshold above the SR pri-

mary target. In this section, we first simulate SR on its own and then augment it with

MAR and arrive at SAFER.


53. The sustainability rule (SR) is based on the assumption that the realized CTF in

the initial year of the drawdown period can be viewed as 67 percent above a newly de-

fined SR primary target. SR distributions are based on multiplying the estimated real geo-

metric portfolio yield by the SR primary target. The SR target distribution is thus

1/(1+sustainability adjustor) times the estimated real geometric portfolio rate of return

times the realized CTF value at the end of the accumulation period. Once the target distri-

bution for FY2024 has been determined, an annual adjustment for inflation is permitted

but without further modification.

1 See appendix 1 for full specification of the sustainability and SAFER rules for the RoP.


54. Under SR, the median drawdown in FY2024 is $36.0 million, or 56 percent below

the target rate of $82 million, and implies an immediate fiscal adjustment of $46 million.

This would result in an unacceptable and massive fiscal contraction. The adjustment dif-

fers from that under MAR, which involves a gradual adjustment responding to CTF per-

formance.

55. The results of simulating CTF performance under SR are shown in Table 4. Com-

parisons are again made with the COFA rule and MAR. SR clearly performs best of the

three rules in terms of protecting the CTF corpus. The percentage of cases in which the

real value of the CTF is above the primary target in FY2050 rises from 24 percent under

COFA to 52 percent under MAR and is 82 percent under SR. In the case of distributions,

the results work in the opposite direction. The average distribution as a percentage of pri-

mary target falls from 75 percent under COFA, to 67 percent under MAR, to 44 percent

under SR. In the case of attaining the FY2050 target distribution, the probability falls

from 39 percent under COFA to 21 percent under MAR to close to zero under SR. The

very poor performance under SR is to be expected as the annual distribution is locked at a

reduced rate from FY2024 onward; only in exceptional cases of market performance sig-

nificantly above average is the probability above zero. SR performs significantly above

MAR in terms of volatility; reducing the probability of a zero distribution during the

drawdown period—reducing it to 0.4 percent. The design of SR and choice of initial

drawdown, inflation adjusted thereafter, is based on a 95 percent performance level at the

redefined lower drawdown and primary target. It is not therefore a surprise that SR elimi-

nates volatility for all practical purposes. Overall, the score of SR is above MAR and

Figure 9 Distributions by number of cases falling in selected ranges under SR rules

-

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

10,000



clearly better than COFA: the outturn under SR significantly improves the value of the

corpus and reduces volatility to a very low level, but at the cost of significantly lower dis-

tributions.

56. The number of cases of achieving given levels of annual drawdowns under the

sustainability rule for selected years is indicated in Figure 9 (see Figure 5 and Figure 7

for comparison). The first thing to notice is that the probability functions for the selected

years are identical, unlike under COFA or MAR, which are significantly different from

SR and each other. This follows from the adoption of a given distribution in FY2024,

which will remain at that level in real terms thereafter unless the CTF collapses. The me-

dian distribution is $33.5 million, which for the FSM would imply a very large adjust-

ment in the initial drawdown period. In comparison to MAR, the simulations for SR indi-

cate a predictable future path, albeit with a very large initial reduction in drawdown.


(SAFER)

57. The SAFER rule starts out with the adoption of the SR level of distribution, but

thereafter adjustments are made on the downside and upside once certain thresholds have

been met. On the downside, MAR kicks in once the CTF value falls below the SR-de-

fined primary target. On the upside, an upward adjustment to distributions is allowed

once the CTF exceeds twice the SR-defined primary target. The starting point is thus a

downward adjustment, but the fixed distribution of SR is relaxed once tail events occur.

58. Referring back to Table 4, the basic metrics for the SAFER simulations are pro-

vided. The starting position is the same as under COFA, MAR and SR, with the corpus

attaining a similar median value. As a general observation, the COFA rules provide re-

sults at the extremes: best in terms of distributions but worst in terms of protecting the

corpus and avoiding volatility. The SAFER rule generally, but not always, produces re-

sults that lie between MAR and SR. SAFER does better than MAR but not as well as SR

in protecting the fund corpus, and vice versa for distributions. Both SR and SAFER pro-

duce good volatility results and outperform MAR. Overall, SAFER, which combines the

characteristics of MAR with SR, yields the best results and attains a score of 72 percent

on the performance indicator.

59. Figure 10 provides an interesting illustration of the results in comparison to both

MAR and SR. The position in FY2024 is identical to that under SR, although not as fa-

vorable as under MAR. However, as time progresses and the corpus accumulates (since

the drawdown rate is below the long-term estimated geometric portfolio yield), enhanced

distributions are allowed. As in the case of SR, the majority of the distributions lie in the

$24 to $41 million range, reflecting the initial reduction to a sustainable level, a level at

which they remain for some time before enhanced distributions occur. Higher distribu-

tions are less likely in all periods, but the number of cases rises for the target distribution.

This reflects that the corpus is rising over time, enabling larger distributions, and a cap is

placed at the target, resulting in a bunching of distributions at that level. In the case of


SR, there is no improvement over time as distributions are designed to remain stationary.

In the case of MAR, distributions are initially more favorable but deteriorate over time,

the opposite of SAFER, which improves.

E. Comparison of the Different Rules

60. In this section, to bring out the differences among the different rules, we provide a

comparison of the performance of the different rules. Under each rule, it is assumed that

the CTF corpus attains a value in FY2023 equal to the median value under the COFA

rules. The starting point is thus identical under each rule. In reality, of course, the starting

point in FY2024 will reflect market performance between the current position and the

end of FY2023. The bands of annual distributions shown in Figure 11 reflect groupings

lying between selected percentiles of the simulation outcomes. The two tails of the distri-

bution—less than 5 percent and greater than 95 percent—are not shown.

61. The first case in Figure 11 is the COFA case and indicates that along the fifth-per-

centile trajectory, distributions fall off rapidly and by FY2030 drop to zero. Along the

25th-percentile trajectory, distributions start out at the maximum $82 million but slowly

decrease after FY2030 until hitting $16 million in FY2050. A wide range of possibilities

occurs in the intermediate percentiles, reflected in the blue and green areas of the graph.

The 50th percentile maintains maximum distributions before starting to decline after

FY2043. The large area represented by the 5th- to 50th-percentile range under COFA

compared with the outcome of the other rules shown in Figure 11 indicates the large

range of possible outcomes under COFA.

Figure 10 Distributions by number of cases falling in selected ranges under SAFER rules

-

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

10,000FY25 FY30 FY35 FY40 FY45 FY50


62. Under the moving adjustment rule (MAR), distributions start out at $68 million.

In the 5th- to 50th-percentile group, distributions decline further in the initial years

through FY2029 by 5 percent in each year and then the distributions fan out from

FY2030, providing $50 million or slightly more along the 50th-percentile trajectory.

Along the fifth-percentile trajectory, distributions fall to $28 million by FY2050 as the

annual decrements of 5 percent reduce the annual drawdowns but prevent fund collapse

in this range. In the upper percentiles, distributions rise up to the target by FY2040 along

the 95th-percentile line but otherwise range between $50 million and the target of $82

million.

63. Under the sustainability rule (SR), all of the percentiles between 5 and 95 lie

along one single line. Distributions fall to $34 million in FY2024, reflecting the median

starting point, and from that point on remain at that level. This is guaranteed by the rules

inherent in SR. While there is a massive 58 percent adjustment in FY2024, from that

point on, distributions can be relied upon by design to remain at that level through the

specification of the rule.

64. The SAFER rule is based on SR but allows for downward and upward movement

in distributions once certain thresholds are met. Distributions also start at $34 million but

are allowed to rise once the corpus has attained a certain level. At the fifth-percentile

level, distributions follow the SR case, but from FY2037 there is a small decline reflect-

ing poor market performance. Under SAFER, upward adjustment is only allowed once

the corpus has attained a safe level, and thus reduced distributions only occur in rare

cases. In the vast majority of percentiles, distributions rise through the period.

0.0

10.0

20.0

30.0

40.0

50.0

60.0

70.0

80.0

90.0

100.0

COFA rules

5-25%of cases

25-50%of cases

50-95%of cases

Amended Compact distributions in FY23 prices


0.0

10.0

20.0

30.0

40.0

50.0

60.0

70.0

80.0

90.0

100.0

Moving adjustment rule


50-95% of cases

5-50% of cases

0.0

10.0

20.0

30.0

40.0

50.0

60.0

70.0

80.0

90.0

100.0

Sustainability rule

5-95% of cases lie along this line


Figure 11 Comparison of distributions under the different rules

0.0

10.0

20.0

30.0

40.0

50.0

60.0

70.0

80.0

90.0

100.0

SAFER


5-50% ofcases

50-95%of cases


F. COFA plus SAFER

65. The question naturally arises from the above discussion as to whether a better re-

sult could be obtained through combining the SAFER and COFA rules—in other words,

adopting a distribution policy that limits distributions in FY2024, as prescribed under SR,

and allowing adjustment for tail risk thereafter, as specified under SAFER. The ad-

vantage of this approach would be that it entails no requirement for a change in law by

the US Congress. Table 5 provides the results. Clearly, the results of the comparison of

the hybrid of COFA and SAFER to that of the unabridged SAFER are very similar, with

SAFER scoring two percentage points above the hybrid. However, there is one critical

difference: that of zero distributions. While occurrences of a zero distribution in at least

one year during the distribution period are eliminated under SAFER, they remain persis-

tently significant, at 12 percent, under the hybrid. This results directly from the overrid-

ing requirement to protect the nominal value of the corpus under COFA. While this sug-

gests that attempts to modify the CTF rules should be pursued, the hybrid does provide a

distribution policy if changes in law are not feasible.

G. The FSM Trust Fund

66. At the start of the amended Compact, the FSM created its own trust fund to set

aside resources for future generations. Contributions to the FSM Trust Fund (FSMTF)

were small in the initial years, but as large fiscal surpluses were generated in the mid-

2010s out of booming fishing fees and the captive-insurance market, the FSM decided to

formalize the process in law. Public law PL 19-67 was signed into law by the president in

Table 6 FSM Compact Trust Fund simulations: running COFA under SAFER

Simulations

Performance Measures COFACOFA plus

SAFERSAFER Rule


Probability of real CTF in FY50 > the FY23 value 24.3% 81.3% 80.2%

Probability of real CTF value > the Primary Target in FY50 19.4% 62.8% 61.7%


Average distribution through FY24-FY50 % target 75.1% 55.9% 56.9%

Proabability of attaining target distribution in FY50 39.2% 34.2% 37.2%

Volatitity results

Probability of a zero distribution between FY24 to FY50 71.9% 11.6% 0.0%

Distribution % prior year counted for reduction years only 29.8% 6.7% 4.7%

Overall performance rating 42.7% 69.3% 71.9%

COFA and SAFER


March 2016 to update, improve and create a disciplined approach to the operation of the

FSM Trust Fund.

1. FSMTF RULES

67. The law mimics the Compact Trust Fund Agreement and other agreements in the

Pacific region through the creation of an A and a B account. However, it differs from the

CTF in many important respects. All contributions are deposited as capital into the A ac-

count, which is to be maintained in real value before any distributions. All earnings, de-

fined as the increase above inflation (US CPI) in the value of the fund during the year, are

transferred to the B account. If earnings after inflation are insufficient to maintain the real

value of the A account, any funds in the B account will be returned to the A account to

make up the shortfall. If there are insufficient funds in the B account, then transfers from

A to B are withheld until the A account is made whole from future earnings. PL 19-67 is

thus far stricter than the COFA, which only protects the nominal value of the A account.

The CTF is not required to make up any deficiencies due to weak market performance.

68. Distributions proceed from the B account and are prescribed at 5 percent of the

average value of the combined A and B funds over the last five years. If there are insuffi-

cient funds in the B account, then whatever is deposited in B can be withdrawn, but no

transfer is permitted from the A account to make up any distributional shortfall. Distribu-

tions are thus pegged to the level of the fund corpus on a moving-average basis but can-

not erode the real value of the A account.

69. Venting is prescribed at the discretion of the FSM Trust Fund board if the value

of the B fund exceeds the sum of all transfers from the A account during the last five

years. The law indicates that there must have been positive transfers in each of the last

five years before venting may occur, so any year with poor market performance would

set the clock ticking again.

70. Finally, the law enables the creation of state sub-accounts. In the simulations un-

dertaken in this paper, this distinction is ignored, and the issue of distribution of resources

to the states is not addressed. Given that the FSM Trust Fund is designed to support the

operational needs of the governments in the FSM, and given that the anticipated shortfall

after the amended Compact takes place at the state level, it is likely that the vast majority

of these funds would be distributed to the states.

2. PERFORMANCE OF THE FSMTF

71. In this section, we consider the performance of the FSMTF in comparison to

COFA and SAFER and consider whether this might be a further alternative formulation

worth considering (see Table 6). All three sets of simulations assume identical starting

values of the respective trust funds, the median value simulated, at the end of FY2023. In

terms of sustaining the value of the corpus, the FSM rules perform better than COFA but

not as well as SAFER. Concerning distributions, the FSM rules attain a result very simi-

lar to COFA but better than SAFER; the average distribution of SAFER is considerably


less than the other two funds. As already described, the SR component in SAFER re-

quires a large upfront cut in distributions, but over time distributions rise. This is revealed

in that the probability of attaining the target value in FY2050 is the same under SAFER

as the other two versions. In terms of volatility, it is to be expected that the FSM rules

fare better than COFA but not as well as SAFER. The number of zero distributions falls

compared with COFA, though it might be expected to rise given the stronger protection

of the corpus. The answer is to be found in that the COFA fund targets the maximum dis-

tribution allowable, whereas the FSM rules are tied to the value of the corpus, which thus

allows greater flexibility. However, the result that in nearly 30 percent of cases the FSM

rules produce zero distributions is unacceptable. The overall performance score lies al-

most halfway between COFA and SAFER.

72. Figure 12 provides the number of cases of distributions falling in selected ranges

for given years. It can be seen that the distributions cluster around the $49 to $57 million

range but flatten as time progresses. The distributions are unlike the COFA distributions

(Figure 5), which cluster around zero distributions or the target. Despite the large number

of zero-distribution years, the FSM rules generate a relatively stable distribution pattern.

H. Increasing Contributions

73. From the foregoing analysis, it is clear that the prospects for the FSM economy in

the post-amended-Compact period without remedial action are dire. While previous sec-

tions indicated that rules can be found that result in a less volatile outcome than the

Table 7 FSM Trust Fund simulations comparing performance under the COFA, SAFER and FSM rules

Simulations

Performance Measures COFA FSM SAFER







Volatitity results




COFA, SAFER and FSM rules at median values


COFA rules, all other alternatives are likely to result in massive reductions in revenues to

support the daily operations of government. The implications in an economy with a tiny

private sector unable to compensate for declining Compact grants would result in eco-

nomic collapse and wholesale migration to the United States and its territories. Clearly,

the CTF will not perform its objectives unless additional funding is found.

74. In this section, it is assumed that the FSM is able to supplement the annual US

contributions, either to the CTF or the FSMTF, through FY2023, out of the abundant na-

tional-government structural fiscal surplus discussed in the FY2016 FSM economic re-

view.1 In chapter V of the economic review, projections of the FSM economy are made

through FY2030, and a structural fiscal surplus of $41 million was identified for FY2017,

remaining largely stationary through FY2023. Under the variety of FSM Trust Fund ar-

rangements considered in this section, it is assumed that with some fiscal adjustment to

maintain essential services, the FSM could contribute $30 million to augment trust fund

resources from FY2018, indexed for inflation thereafter. It is also assumed that the

FSM’s current trust fund is used to augment the process. In FY2016, the FSM trust had

attained a value of $82.6 million. It is further assumed that the FSM will contribute a fur-

ther $15.4 million in FY2016 and FY2017 (the current level), before any new trust mech-

anism is established. Allowing for investment returns, it is projected the FSM Trust Fund

1 The Graduate School USA, Federated States of Micronesia Fiscal Year 2016 Economic Re-

view, 2016, Honolulu, Hawaii.

Figure 12 Distributions by number of cases falling in selected ranges under the FSM rules

-

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

10,000FY25 FY30 FY35 FY40 FY45 FY50


could attain a value of $126 million by end of FY2018. It is lastly assumed that the FSM

resources are invested in a similar portfolio to the COFA funds.

75. Figure 13 indicates the probability distribution of the likely size of the CTF in

FY2023 with additional FSM contributions. In comparison to Figure 4 (without FSM

contributions), the probability of achieving the primary target in FY2023 has increased

from 7 to 32 percent. The median value also rises from $1,139 million to $1,476 million,

a significant 30 percent increase, which places the FSM on a much sounder track going

into the post-amended-Compact period.

76. A variety of alternative investment strategies for the FSM funds present them-

selves going forward, and four are outlined below. In all cases, it is assumed that once the

total value of the trust funds exceeds twice the primary target, the FSM ceases to make

further contributions.

1. COFA++: FSM resources are used to augment the existing COFA Trust Fund.

2. PL 19-67: FSM resources are accumulated as specified under FSM Congress PL

19-67. For purposes of comparison to the other variants, distributions are capped

at the COFA target level, although PL 19-67 allows larger distributions. Further,

the venting of capital from the B account to the A account once the threshold is

reached is not adopted (at the discretion of the board), as this leads to an inferior

result.

Figure 13 Probability Distribution of the Compact Trust Fund in FY2023 with FSM contribu-

tions

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

4.5%

500 1,000 1,500 2,000 2,500 3,000

Median value = $1,476m;11% below primary target

Primary target = $1,655m;32% chance of attainment


3. SAFER++: Both the CTF and FSM resources are comingled in a new joint US

FSM fund requiring US congressional amendment to the existing agreement.

4. FSM Buffer: FSM resources are maintained in a separate fund and used to sup-

plement distributional shortfalls under the COFA rules when experienced, but

otherwise accumulated in the local fund.

i COFA++

77. Table 7 provides an indication of the standard results. As to be expected,

COFA++ with the additional funding reveals similar results to the existing smaller COFA

fund. The outcome is favorable in terms of maintaining fund levels and distributions but

remains woefully inadequate in terms of volatility. The probability of a zero distribution

during the drawdown phase falls from the 72 percent under the un-augmented COFA

fund to 41 percent in the joint, still unacceptably high and fiscally unmanageable. The

overall score of the performance indicator improves to 82 percent. Further simulations,

not reported here, indicate that these results are not significantly improved even with very

large additional infusion of funds. The existing CTF arrangements are deeply flawed.

ii PL 19-67

78. The results under PL 19-67 are an improvement on the COFA++ variant. The

probabilities of maintaining the total fund corpus during the period are enhanced by peg-

ging the value of distributions to the size of the FSM Trust Fund. Perhaps surprisingly,

the level of distributions is very close to COFA++. However, volatility still remains a sig-

nificant problem, with a 14 percent chance of a zero distribution and a significant number

Table 8 Augmenting trust fund resources: performance results

Simulations

Performance Measures COFA ++ PL/19-67 SAFER ++ FSM buffer







Volatitity results




Additional FSM Contributions


of years when distributions decline. Overall, a respectable score of 89 percent is attained,

but clearly, PL 19-67 does not provide a satisfactory mechanism for the support of gov-

ernment operations.

iii SAFER++

79. Under the SAFER++ simulation, it is assumed that the CTF subsidiary agreement

is amended by the US Congress and the revised regime permits the implementation of the

SAFER rule. US contributions and FSM resources contribute to a new CTF during the

accumulation phase. In FY2024, the SAFER rule is implemented, and a new distribution

is determined based on maintaining a sustainable fund corpus thereafter. Given the lack

of resources projected in FY2023, this will imply a reduction in distributions. To make up

the loss, the continuing FSM national-government surplus ($30 million in FY2019, infla-

tion adjusted) is first drawn on to make up the shortfall, and any residual funds are con-

tributed back into the CTF. This process continues until the CTF corpus achieves a level

twice that of the primary target. At this point, further FSM contributions cease. However,

only in 49 percent of cases is this condition achieved by FY2050, with the implication

that the national government will be required to make transfers that support the opera-

tions of the state governments for many years to come.

80. Table 7 indicates that, overall, SAFER++ provides high levels of probability of

maintaining the corpus and distribution levels. Most importantly, volatility is eliminated.

While the overall level of the performance indicator clearly surpasses that of COFA++, it

is only slightly higher than under PL 19-67. However, the clearly superior ability to avoid

zero or reduced distributions makes it a clear favorite.

iv FSM Buffer

81. The FSM buffer trust fund is exceptionally simple: all of the allotted FSM na-

tional-government fiscal surplus is allocated to an FSM trust fund. In FY2024 and on-

ward, when there is a shortfall in distribution from the COFA component, sufficient

funds are transferred from the FSM fund to make up the shortfall. This process continues

until two conditions hold: (i) the combined CTF and FSMTF corpus achieves a level

twice that of the primary target, and (ii) the level of the FSMTF has attained five times

the target distribution. At this point, further FSM contributions cease. Table 7 indicates

that this approach provides a high score on the performance indicator matching PL 19-67

and SAFER++. While the ability to protect the corpus does not match the other variants,

distributions are higher and volatility is largely eliminated.

82. Table 7 indicates the overall results of PL 19-67, SAFER++ and the FSM buffer

are all very similar and not statistically different. However, there are other considerations.

PL 19-67 has an unacceptable chance of zero distributions and does not afford a reliable

mechanism to support its objectives to fund government operations. While the FSM

buffer approach is simple and does not require congressional action, greater inspection of

the data reveals that in the lower percentiles, the buffer option has a greater tendency to


collapse than SAFER++. This can be inferred from Table 7, which indicates that

SAFER++ has a higher score on fund corpus but lower on distributions, which thus indi-

cates longer-term sustainability. This report favors SAFER++, but SAFER++ comes at

the cost of requiring congressional action.

v Graphical Comparison

83. Figure 14 provides a graphical representation of the results in this section to aid

understanding of the operation of the different rules. COFA++ with the additional funds

indicates three bands of distributions. In the worst case, along the zero-percentile line,

distributions quickly drop to zero and remain at the level. Along the fifth-percentile line,

distributions fall off rapidly but stabilize at around $15 to $20 million. Along the 10th-

percentile line, results are significantly improved, and along the 15th-percentile line and

above, full distributions are achieved.

84. PL 19-67 provides an interesting wave of distributions. The results for the lowest

percentile band (zero to five) are similar to COFA++ through FY2030 but indicate a

worse result thereafter. In the 5th- to 10th-percentile band, distributions fall in the initial

years but improve after FY2029, reflecting the buildup of funds in the FSMTF. The other

bands shown in the graph indicate similar trends: initially falling rapidly and then drifting

upward. Along the 25th-percentile line, all distributions attain the target level. In compar-

ison to COFA++, the results might seem to suggest better results are obtained through the

FSM investing its resources in the CTF. However, Table 7 reminds us that PL 19-67 pro-

vides a preferred overall score and far fewer zero distributions.

85. The simulations under SAFER++ indicate a much more acceptable outcome: in

the worst case, distributions never drop below half the target—that is, $40 million. In the

5th- to 50th-percentile band, distributions are all above $60 million and rise to the target

in the later years. In the upper percentile band (50th to 95th), distributions are close to

target and provide a favorable result.

86. In the FSM buffer simulation, only in the zero- to fifth-percentile band are distri-

butions less than target, and in the worst cases distributions drop to $30 million, the an-

nual contribution from the FSM to supplement CTF shortfalls. Comparing the two lowest

bands of FSM buffer and SAFER++ suggests that some reduction in distributions under

SAFER++ is preferable to the larger fiscal-shock potential under the worst-case scenarios

under buffer. However, in the higher percentiles, FSM buffer would be preferred. The re-

sults are close, and choice would depend on the penalty attached to poor distributions,

against a more assured but lower average.


0.0

10.0

20.0

30.0

40.0

50.0

60.0

70.0

80.0

90.0

100.0 Amended Compact distributions in FY23 prices

5-10% of cases

0-5% of cases

10-15% of cases

COFA++

0.0

10.0

20.0

30.0

40.0

50.0

60.0

70.0

80.0

90.0


0-5% of cases

5-10% of cases

COFA+ PL 19-67

10-15% of cases

15-20% of cases

20-25% of cases

0.0

10.0

20.0

30.0

40.0

50.0

60.0

70.0

80.0

90.0


0-5% of cases

5-50% of cases

SAFER++

50-95% of cases


vi Conclusion

87. The results of the simulations involving additional FSM contributions indicate

that the FSM can have a very real impact on establishing a sustainable fiscal environment

for the future, although the need for fiscal adjustment remains. While PL 19-67 legislated

a disciplined approach to the establishment of a sustainable FSM Trust Fund, the estab-

lishment of dual A and B accounts does not resolve the flaws in the existing COFA

Agreement. PL 19-67 should be amended either to support an amended COFA Agree-

ment under a regime such as SAFER++, or in its absence through the adoption of the

FSM buffer rule. The overall results of SAFER++ and the FSM buffer are largely indis-

tinguishable, although SAFER++ displays greater long-term sustainability. The better re-

sults obtained through additional FSM contributions and adoption of a rule such as FSM

buffer should not discourage attempts to amend the CTF Agreement. The FSM contribu-

tions proposed in this paper, while entirely feasible, are far from accepted as any sort of

policy commitment in the FSM. Failure to reform the CTF Agreement runs the risk that

the additional FSM contributions will not be forthcoming and the nation will be forced

into a highly volatile fiscal environment.

Figure 14 Comparison of distributions under different FSM contribu-

tion regimes

0.0

10.0

20.0

30.0

40.0

50.0

60.0

70.0

80.0

90.0


0-5% of cases

5-100% of cases meet target

COFA + FSM TF as buffer

42

IV. THE RMI COMPACT TRUST FUND

A. Performance of the Compact Trust Fund (FY2004–FY2017 and projected to FY2023)

1. BACKGROUND

88. The establishment of the Trust Fund for the People of the RMI (CTF) was a major

feature of the amended Compact. The trust fund was created, according to the preface of

the CTF Agreement, “to contribute to the long-term budgetary self-reliance of the RMI

… [and] to provide the Government of the RMI with an ongoing source of revenue after

FY2023.” The design features of the trust fund related to distributions to the RMI from

FY2024 and thereafter are specified in the CTF Agreement, Articles 16(7) (a) and (b).

The explicit linkage of distributions and the fully inflation-adjusted value of the Compact

annual grant assistance provided in FY2023 has the potential to create expectations that

such levels of support from the CTF may be forthcoming. However, the US government

has made it clear that neither the terms of the amended Compact nor the terms of the CTF

Agreement make any guarantee, or even a commitment, that the trust fund will be able to

sustainably achieve distributions of any specific size.

89. Still, even the US Government Accountability Office (GAO) in its June 2007 re-

port1 completed its analysis based on the assumption that distributions would equal the

above-described (maximum) level. When challenged on that assumption with the fact that

such levels of disbursement are neither required nor guaranteed, the GAO countered that

“[they] believe it is appropriate to undertake a projection of the likely disbursements

against that benchmark.”2 The GAO also noted that “[they] believe that careful analysis

of the trust funds each year will help establish realistic expectations.”3

90. This chapter is prepared in fulfillment of our general terms of reference to de-

scribe key economic trends and describe policy options for consideration by our readers,

especially RMI leaders and officials from the US and the RMI engaged in Compact man-

agement. Given the immense importance of the CTF to the RMI’s long-term prospects

for achieving economic self-reliance, our review provides an analytical perspective in ad-

dition to that provided through the published reports of the RMI CTF Committee, the US

GAO and the ADB. The authors use the maximum level of distribution to complete prob-

ability-based (stochastic) projections for the period after FY2023, while noting fully the

risk of falling short and the need for RMI leaders to continue to strengthen their policy

1. GAO-07-513, “Compacts of Free Association: Trust Funds for Micronesia and the Marshall

Islands May Not Provide Sustainable Income,” June 2007, www.gao.gov/cgi-

bin/getrpt/GAO-07-513. 2 Ibid, Appendix V, p. 56. 3 Ibid, Appendix V, p. 56.

The RMI Compact Trust Fund 43

focus on alternative measures to mitigate the risk of potential periodic (or even sustained)

fiscal shocks.

91. As noted in previous GSUSA annual economic reviews, the CTF Agreement in-

cludes certain technical characteristics likely to become problematic during the distribu-

tion period. It is inarguable that the best interest of all parties would be served if, over the

long term, the real value of the CTF was protected and robust mechanisms ensured the

relative stability of annual distributions from the CTF to the RMI. Unfortunately, as cur-

rently specified, and in the absence of stellar investment-return rates or large additional

contributions over the remaining accumulation period, the real value of the CTF corpus

has an unacceptably high likelihood (27 percent probability) of declining over the course

of the distribution period; perhaps more urgently, the stability of annual distributions will

be at risk. Immense and repeated fiscal shocks are more likely to arise because of the spe-

cific characteristics agreed to by the parties and enacted in US law. The result is, again,

an unacceptably high likelihood (35 percent probability) of at least one fiscal year in

which a zero distribution would be allowed under prevailing rules. While amending these

provisions is no easy task—especially since US Congressional approval is required—the

RMI CTF Committee, in collaboration with JEMFAC and with the US and RMI govern-

ments, may wish to consider (a) modifying problematic design characteristics of the

buffer-account mechanism; (b) modifying a distribution mechanism that results in timing

that conflicts with the prevailing practice of estimating annual allocation decisions each

January and confirming them each August in advance of the subject fiscal year; and (c)

devising distribution rules that could better protect the real value of the corpus over the

long run while also reducing the volatility of distribution levels and reducing the fre-

quency of shortfalls in annual fiscal support to the RMI.

2. PERFORMANCE MONITORING

92. This subsection presents a CTF simple sufficiency estimate and related analysis.

That estimate is defined as the size the CTF would need to achieve by the end of FY2023

to support a smooth and sustainable transition from US-appropriated annual sector grants

to fully inflation-adjusted annual CTF distributions to the RMI. The simple sufficiency

estimate is updated to reflect actual outcomes to date, particularly with respect to the par-

tial inflation adjustment that has been applied through the FY2019 budget estimates and

with respect to projected inflation going forward. Future inflation projections are linked

to US Congressional Budget Office published projections through FY2025.1 Using these

assumptions, the level of Compact sector grants in FY2023 is projected at $35.6 million.

Of this, $26.5 million is scheduled to terminate after FY2023, with the remaining $9.1

million scheduled to continue to flow via sector grants dedicated to Kwajalein-based ac-

tivities. With full projected inflation (at 2.05 percent) for FY2024, the $26.5 million is

1 http//:www.cbo.gov/publication/45066, Economic Data and Projections, January 26, 2015,

Table A-3, prices (fiscal years).

http://www.cbo.gov/publication/45066


adjusted upward to $27.0 million. That portion of the grants that does not continue is

used in this review to estimate the simple sufficiency estimate.

93. It is assumed that the RMI CTF investment strategy at that time would need to

provide for a prudent balance of risk while allowing for long-term growth. From FY2024

onward, and for estimation purposes only, a balanced investment allocation is assumed,

as detailed in the following section. Over a 92-year period, the real rate of return using

econometric estimation techniques is 5.0 percent. Thus, if inflation were to average 2 per-

cent, a nominal rate of return of 7 percent is implied. Dividing the $27.1 million (maxi-

mum) distribution by a 5.0 percent real rate of return yields a simple sufficiency target of

$535 million.

94. Using the above-detailed assumptions and starting with the end-of-FY2017 RMI

CTF value of $354,656,481, the rate of return required to achieve the simple sufficiency

estimate for the RMI CTF of $544 million would be just 2.2 percent annually for the six

remaining years from FY2018 to FY2023. This assumes planned contributions from the

US and the Republic of China, the subsequent contributor, are fulfilled. Such a rate of

growth is more likely than not; however, a risk remains of a less favorable outcome. Us-

ing probability analysis, the median projected level of the RMI CTF at the end of FY2023

is $715 million, or 131 percent of the simple sufficiency estimate. In the same modeling

process, 92 percent of the cases resulted in an FY2023 balance equal to or greater than

the simple sufficiency target of $544 million.

95. Still, it is clear that the long-term projected rate of return of 7.0 percent in nomi-

nal terms modestly exceeds the rate of return experienced by the RMI CTF during the pe-

riod it has been invested, FY2006–FY2017. The experienced asset-weighted rate of re-

turn from FY2006 through FY2017 has been 6.75 percent. The asset-weighted rate of re-

turn from initial funding on June 1, 2004, through the end of FY2017 is 6.38 percent, re-

flecting the delay in getting the CTF established and fully invested at the outset of the

amended-Compact period.

96. The RMI has funded the D account within the CTF mechanism. As of the end of

FY2017, the value of that account was $15.1 million, or just over 4 percent relative to the

size of the RMI CTF (A plus C accounts) at that date. To the extent the RMI fulfills some

of its ongoing commitments or emerging plans and makes additional contributions to the

D account or a separate fund dedicated to the goal of post-FY2023 fiscal sustainability, it

could develop an important supplemental funding source to mitigate periodic or sustained

fiscal shocks.

97. Consistent with recommendations in recent CTF annual reports, joint or unilateral

efforts to mobilize additional contributions—from domestic and external sources—to the

CTF would improve the RMI’s long-term fiscal stability and economic security. Simi-

larly, the RMI government’s cabinet-endorsed long-term fiscal framework (LTFF) com-

mitments to develop expenditure and revenue policies that take into account the risks

faced after FY2023 are both prudent and promising.


98. It should be noted that achieving a CTF size that matches or narrowly exceeds the

simple sufficiency estimate does not, by any means, eliminate the risk going forward of

subsequent severe and repeated fiscal shocks. Periodic strong performance of the CTF

does not eliminate the urgency to consider opportunities to achieve mutual agreement on

a distribution policy or amendments to enhance the CTF agreement. In the following sec-

tion, a more sophisticated, risk-inclusive form of analysis is presented to analyze the

range of outcomes that might prevail given the volatility of market returns and the uncer-

tainty of the sequence of those returns over time. That analysis defines a SAFER alterna-

tive that, in effect, requires a larger fund balance than the “simple sustainability” esti-

mate. As shown in Figure 15, that estimate is for a fund size of $908 million.

99. A range of factors have combined to result in a CTF value that is now above the

projected path to achieve the simple sufficiency estimate by the end of FY2023. The most

important factor is the effect of contributions from a third party, but also the investment

climate that has prevailed from FY2006 through FY2017. Addressing other factors, the

authors provided a lengthy discussion on delays in establishment of the CTF and further

delays in implementing an investment strategy (see the FY2011 report at

http://www.econmap.org).

Figure 15 Projected RMI Trust Fund Value through FY2023

http://www.econmap.org/




100. This section of the study is forward looking and simulates performance and ability

to achieve the CTF principles outlined in chapter II over the remaining accumulation and

drawdown period. The simulations use Monte Carlo analysis, and the method is described

in more detail in appendix 1. Figure 16 provides a depiction of the simulated CTF at the

end of FY2023 before drawdowns commence. It indicates that from a value at the end of

FY2017 of $355 million, the fund is likely to attain a value of $715 million in FY2023

(the median simulated value). While the median value is above the level of the primary

target of $544 million, the probability of attaining the primary target is high at 87 percent.

However, it must be borne in mind that the primary target is only a benchmark and is

based on a risk-free assumption. Figure 16 thus indicates that while the likely level of the

CTF in FY2023 will be above the primary-target level, there will still remain a significant

risk that the CTF will be below this level and not sufficient to provide a secure stream of

benefits to support government operations in the RMI thereafter.

101. Table 8 provides statistics based on the performance criteria defined above for the

set of simulations undertaken in this study. Focusing on the results for the COFA simula-

tions and the measures for protecting the corpus, the probability of maintaining the real

value of the corpus between FY2023 and FY2050 is 73 percent, less than the 88 percent

probability of attaining the primary target in FY2023.

Figure 16 Probability Distribution of RMI Compact Trust Fund in FY2023, $’millions

Median expected value = $715 million

Primary-target estimate = $544 million 87% chance of attainment


102. The second section of Table 8 indicates the nature of the annual distributions that

can be anticipated after FY2023. The average distribution throughout the period is 94

percent, while the probability of attaining the target distribution in FY2050 is 83 percent.

In terms of volatility, the probability of experiencing a zero distribution in the FY2024–

FY2050 period is a large 35 percent while the percentage of years with downward adjust-

ment in the real value of distributions is 9 percent. These results bring out the volatile na-

ture of the COFA rules: there is thus a tendency to the extremes of either meeting the tar-

get, which is reflected in a high average drawdown of 94 percent, or failing entirely,

which is reflected in the high probability of experiencing at least one zero distribution.

Finally, the overall performance rating of the CTF under the COFA distribution mecha-

nism is 81 percent. On its own, this benchmark has little value without comparison to the

alternative simulations discussed below. These results confirm the previous studies’ find-

ing that the projected CTF distributions under the COFA rules will be highly volatile and

fail to support fiscal stability and the operational needs of the RMI government.

2. VOLATILITY

103. Figure 17 provides some more information on the volatility of the changes in an-

nual drawdowns. The figure indicates the number of cases, or probabilities, of distribu-

tions falling in each of the ranges indicated selected at five yearly intervals. Because of

the high level of funding of the RMI CTF, the outcomes for each of the selected years lie

very close together compared with the outcomes in FSM, where there is a significant dif-

Table 9 RMI Compact Trust Fund simulated results and performance

Simulations

Performance Measures COFA Rules

Moving

Adjustment

Rule

Sustainability

RuleSAFER Rule







Volatitity results




Rule Sets


ference. At the start of the amended Compact in FY2025, in nearly all cases, over 97 per-

cent, distributions reach the maximum of $27 million. It is rare to have a case with less

than full distributions. By the time we get to FY2035, the situation has deteriorated and

only in 90 percent of cases are distributions at the maximum, with 1 percent now record-

ing zero observations. And in FY2050, the number of full distributions has dropped to 83

percent, with the number of zero distributions rising to 8 percent. The graph indicates that

the COFA rules favor distributions that are large but declining over time, with a growing

number of zero distributions. Clearly, stable fiscal management cannot be sustained in

such an environment.

104. The volatility of the CTF mechanism is also well established through examination

of the results of individual simulations. The Monte Carlo analysis adopted in this study

follows a standard approach of running 10,000 simulations to derive the statistics pre-

sented. In Figure 18, five simulations have been selected at random.1 Of the 10,000 simu-

lations, the 5th, 7th, 9th, 14th, and 16th simulations out of the first 20 were selected using

Excel’s random-number generator. In simulation 5, the results are perfect. The CTF starts

out from an above-average position, but market returns are about average during the dis-

tribution period, with a nominal average return of 8.8 percent (after fees) compared with

an

1 Figure 18 is based on a similar diagram presented in the ADB study, which vividly displays

the inadequacies of the amended Compact distribution mechanism.

Figure 17 Distributions by number of cases falling in selected ranges under COFA rules

-

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

10,000FY25 FY30 FY35 FY40 FY45 FY50





Sim 5

$0m

$20m

$40m

$60m

$80m

$100m

$120m

$140m

$160m

$180m

$0.0b

$0.5b

$1.0b

$1.5b

$2.0b

$2.5b

$3.0b


Sim 5

$0m

$20m

$40m

$60m

$80m

$100m

$120m

$140m

$160m

$180m

$0.0b

$0.5b

$1.0b

$1.5b

$2.0b

$2.5b

$3.0b


Sim 7

$0m

$20m

$40m

$60m

$80m

$100m

$120m

$140m

$160m

$180m

$0.0b

$0.5b

$1.0b

$1.5b

$2.0b

$2.5b

$3.0b


Sim 9





expected return of 8.9 percent; the nominal geometric return is 8.5 percent above the ex-

pected average geometric yield of 8.1 percent.

105. In simulation 7, the results are not as favorable. Although a generally satisfactory

output is achieved, there is a large distribution shortfall in FY2047 of $12 million, or 28

percent. The trust fund corpus starts out at $858 million above the expected median simu-

lated value of $708 million, but market returns during the period, both nominal and geo-

metric, are more than two percentage points below the benchmark.

106. Simulation 9 produces an interesting result, with yields above the expected aver-

ages. However, in three periods, FY2026, FY2036 and FY2049, there are large distribu-


Average rate of return 7.4% Geometric rate 6.5

Figure 18 Randomly selected CTF trajectories and drawdowns FY2024-

FY2050

$0m

$20m

$40m

$60m

$80m

$100m

$120m

$140m

$160m

$180m

$0.0b

$0.5b

$1.0b

$1.5b

$2.0b

$2.5b

$3.0b


Sim 16

$0m

$20m

$40m

$60m

$80m

$100m

$120m

$140m

$160m

$180m

$0.0b

$0.5b

$1.0b

$1.5b

$2.0b

$2.5b

$3.0b


Sim 14




tional shortfalls of 25 percent, 32 percent and 36 percent, respectively. Having a gener-

ally well-funded trust fund with above-average market returns is no guarantee that the

CTF will generate the target distribution.

107. In simulation 14, the CTF starts out below average, with a value of $596 million,

significantly below the median value of $708 million. Market returns are two percentage

points below average, and yet the CTF performance is satisfactory, meeting the target

throughout the period. The results of simulation 14 are the opposite of simulation 9 in the

sense that in simulation 9, market performance is good but distributions are not satisfac-

tory, while in simulation 14 the opposite holds.

108. In the final simulation, 16, market returns are slightly less than average, and there

is a healthy growth in the fund corpus. However, in FY2016, after a period of weak mar-

ket returns the C account is exhausted and the first zero-distribution return is experienced

in the five simulations selected for discussion.

109. The five simulations displayed are typical of the COFA distribution-rule specifi-

cation: periodic large swings in distribution with periodic zero distributions requiring un-

manageable fiscal adjustments. In certain instances, the results are perverse, in that even

in the case of a well-funded trust fund, reduced or zero distributions are projected to oc-

cur under the COFA rules.

C. Moving Adjustment Rule

110. In this section, an alternative rule is deliberately designed to smooth the volatility

of the COFA rules, but in the process it removes the A and C account mechanisms. Under

this rule, known as the moving adjustment rule (MAR), distributions are made directly

from the remaining consolidated CTF. In the MAR case, it is assumed a downward ad-

justment, or decrement, of 5 percent of the previous year’s distribution will be made if a

three-year moving average of the CTF value falls below the primary target.1 Downward


tio of the actual CTF value to primary target). At this point, an upward adjustment, or in-

crement, of 2 percent is made. Adjustment is thus asymmetric: on the downside, adjust-

ment is more rapid, and on the upswing, adjustment is slower in order to allow the CTF

to return more rapidly to the primary target. All distributions are made directly from the

CTF, and there is no buffer account. On the upside, when the CTF value exceeds the pri-

mary target there is no allowance for venting. However, some adjustments to the CTF

may be desirable in those circumstances in which the fund grows very large. Such a pro-

vision exists in the existing trust fund agreement to allow withdrawals for special pur-

poses.

1 See appendix 1 for full specification of the moving adjustment rule.



111. Referring back to Table 8, the basic metrics for the MAR simulations are pro-

vided. The starting position is the same as under the COFA case. In terms of sustaining

the CTF corpus, MAR performs slightly better than COFA. Under MAR, the probability

of maintaining the real value of the CTF through FY2050 is 74 percent, a 1 percent im-

provement over COFA. Similarly, the probability of the CTF being above the primary

target in FY2050 is 79 percent, again 1 percent higher than under COFA.

112. In terms of achieving the target distribution, the average distribution over the pe-

riod is almost identical to COFA, while the probability of attaining the target in FY2050

falls from 83 percent under the COFA rules to 74 percent under MAR. In terms of vola-

tility, there is a very significant improvement, with the probability of a zero distribution

during the drawdown phase falling from 35 percent to 0.1 percent. Similarly, the proba-

bility of reductions in distributions falls from 9 percent under COFA to 1 percent under

MAR. In effect, the annual adjustment under MAR reduces volatility through smoothing

the annual withdrawals.

2. VOLATILITY

113. Figure 19 (the companion to Figure 17) presents the number of cases, or probabil-

ity distribution, of drawdowns falling in selected five yearly intervals. The results are

very similar to those of the COFA simulations presented in Figure 17, in which the vast

majority of results hit the maximum distribution of $27 million. However, there are two

Figure 19 Distributions by number of cases falling in selected ranges under MAR rules

-

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

10,000



important differences: there are no zero distributions, but the chances of meeting the tar-

get distribution have fallen. In effect, the zero distributions of COFA have been traded for

a reduced number of target distributions. The moving adjustment mechanism has allowed

distributions to respond to the health of the CTF and market forces, and avoided the mas-

sive disruptions of COFA.

114. Figure 20 provides two selected simulations chosen to indicate a typical path of

adjustment when market returns have been weak. The exercise is intended to reveal the

smooth path of adjustment under MAR, rather than illustrate the more normal case when

the target distribution is attained. In simulation 11, the CTF is higher than the primary

target in FY2023, recording a value of $776 million, but market returns are poor through-

out the distribution period. The nominal value of distributions achieves the target in the

initial years, but after FY2029 a downward adjustment is required, reflecting the poor re-

turns in prior years. By FY2036, the markets are experiencing improved performance,

$0m

$5m

$10m

$15m

$20m

$25m

$30m

$35m

$40m

$45m

$50m

$0.0b

$0.5b

$1.0b

$1.5b

$2.0b

$2.5b


Sim 11

Figure 20 Randomly selected CTF trajectories and drawdowns under MAR,

$0m

$5m

$10m

$15m

$20m

$25m

$30m

$35m

$40m

$45m

$50m

$0.0b

$0.5b

$1.0b

$1.5b

$2.0b

$2.5b


Sim 24




and an upward adjustment in distributions is possible until the maximum is once again at-

tained in FY2047. Simulation 24 is similar to simulation 11. The CTF starts out at $507

million, below the median expected value of $708 million. Market returns are above

those in simulation 11, but below those in the benchmark. Yields and returns stay low for

several years, but after FY2032 better returns kick in and distributions are able to return

to the target, although lower returns at the end of the period suggest this may be short

lived.

115. MAR has been designed to generate a smooth adjustment path, with known decre-

ments or increments, that responds to the funding status of the CTF. The principle has

been to design a rule that reduces the impact on the operation of fiscal management.

Clearly, MAR performs very well in reducing volatility from one year to the next and in

eliminating zero distributions. Overall, MAR attains 87 percent on the performance indi-

cator compared with the 82 percent under COFA. However, while the results under the

MAR case are superior, they cannot be considered satisfactory in that significant fiscal

adjustment is imposed on the RMI economy that would undermine financial stability, as

indicated in Figure 20.











mary target. In this section, we firstly simulate SR on its own and then augment it with





fined SR primary target. SR distributions are based on multiplying the estimated real geo-

metric portfolio yield by the SR primary target. The SR target distribution is thus







118. Under SR, the median drawdown in FY2024 is $22.5 million, or 17 percent below

the target rate of $27.1 million, which implies an immediate fiscal adjustment of $4.6

million. This would result in a very large fiscal contraction, although not nearly as mas-

sive as in the FSM. The adjustment differs from that under MAR, which involves a grad-

ual adjustment responding to CTF performance. SR fixes an inflation-adjusted distribu-

tion in FY2025 and thereafter, and allows for no variation once the initial adjustment has

been completed.

119. The results of simulating CTF performance under SR are shown in Table 8. Com-

parisons are again made with the COFA rule and MAR. SR clearly performs best of the

three rules in terms of protecting the CTF corpus. The percentage of cases in which the

CTF is above the FY2023 value in FY2050 rises from 73 percent under COFA to 74 per-

cent under MAR and is 83 percent under SR. In the case of distributions, the results work

in the opposite direction. In terms of distributions through FY2014–FY2050, the average

falls from 94 percent of the target under COFA and 95 percent under MAR to 80 percent

under SR. The probability of attaining the target distribution in FY2050 falls from 83 per-

cent under COFA to 75 percent under MAR to 20 percent under SR. The poor perfor-

mance under SR for distributions is to be expected as the annual distribution is locked at

a reduced rate from FY2024 onward. SR performs on par with MAR in terms of volatil-

ity. Both record far superior results to COFA and effectively eliminate zero distributions.

120. Overall, the score of SR is below both those of COFA and MAR. This result is at

odds with the FSM case, in which SR outperforms both COFA and MAR. The initial

funding levels of the CTF in the RMI case are far superior to those in the FSM case: the

FSM COFA rules score 43 percent compared to 81 percent in the RMI. The better start-

ing position of the RMI results in closer results between the different rule sets. Under SR,

the gains from sustaining the level of the corpus are outweighed by large reductions in

distributions compared to the alternatives. Although volatility is reduced, the results are

not as favorable as COFA or MAR and, overall, SR underperforms.

121. The number of cases, or probability, of achieving given levels of annual draw-

downs under the sustainability rule for selected years is indicated in Figure 21 (see Figure

17 and Figure 19 for comparison). The first thing to notice is that the probability func-

tions for the selected years are identical, unlike under COFA or MAR, which are signifi-

cantly different from SR. This follows from the adoption of a given distribution in

FY2024, which will remain at that level in real terms thereafter unless the CTF collapses.

The median distribution is $22.5 million, which for the RMI would imply a significant 17

percent, or $4.4 million, adjustment in the initial drawdown period. In comparison to

MAR, the simulations for SR indicate a predictable future path, albeit with a large initial

reduction in drawdown.



(SAFER)








vided. The starting position is the same as under COFA, MAR and SR with the corpus at-

taining a similar median value. As a general observation, the COFA rules provide results

at the extremes: best in terms of distributions but worst in terms of protecting the corpus

and avoiding volatility. The SAFER rule produces results that lie between MAR and SR.

SAFER does better than MAR but not as well as SR in protecting the fund corpus and

vice versa for distributions. The three alternative rules produce good results in reducing

volatility. Overall, SAFER, which combines the characteristics of MAR and SR, yields

the best results and attains a score of 88 percent on the performance indicator. However,

there is not a lot of difference between SAFER and MAR.

124. Figure 22 provides an illustration of the results in comparison to COFA, MAR

and SR (see Figure 17, Figure 19 and Figure 21 for comparison). The position in FY2024

is identical to that under SR, although not as favorable as that under MAR. However, as

Figure 21 Distributions by number of cases falling in selected ranges under SR rules

-

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

10,000



time progresses and the corpus accumulates (since the drawdown rate is below the long-

term estimated geometric portfolio yield), enhanced distributions are allowed. As in the

case of SR, a large number of distributions lies in the $16 to $24 million range, reflecting

the initial reduction to a sustainable level, a level at which they remain for some time be-

fore enhanced distributions occur. However, under SAFER there is a bunching of distri-

butions at the target, reflecting the upward adjustment possible under SAFER, an adjust-

ment that grows over time. In the case of SR, there is no improvement over time as distri-

butions are designed to remain stationary. In the case of MAR, distributions are initially

more favorable but deteriorate over time, the opposite of SAFER, which improves.

125. Clearly, the SAFER rule favors future generations in terms of both drawdowns

and maintaining the level of the CTF. The closeness of the overall results between the

MAR and SAFER rules, however, raises the question of which is to be preferred. The

SAFER rules provide an unambiguously better result when the CTF is significantly un-

derfunded, as indicated in chapter III for the case of the FSM. However, these benefits

are eroded as the funding level of the corpus in FY2024 improves. In essence, while

MAR includes a moving adjustment to reduced or falling levels of fund corpus, it does

not adjust sufficiently quickly to avoid fund collapse when the corpus is a long way be-

low the primary target. SAFER, on the other hand, allows for an immediate large adjust-

ment and subsequent growth in the corpus thereafter under normal market returns.

Figure 22 Distributions by number of cases falling in selected ranges under SAFER

-

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

10,000



E. Comparison of the Different Rules

126. In this section, to bring out the difference between the different rules, we provide

a comparison of the performance of the different rules. Under each rule, it is assumed that

the CTF corpus attains a value in FY2023 equal to the median value under the COFA

rules; the starting point is thus identical under each rule. In reality, of course, the starting

point in FY2024 will reflect market performance between the current position and

FY2024. The bands of annual distributions shown in Figure 23 reflect groupings lying

between selected percentiles of the simulation outcomes. The two tails of the distribution

less than 5 percent and greater than 95 percent are not shown.

127. The first case in Figure 23 is the COFA case, and it indicates that along the fifth-

percentile trajectory, distributions fall off and decline through FY2050, just avoiding bot-

toming out to zero. Along the 25th-percentile trajectory, distributions start out at the max-

imum $27 million and maintain the target distribution throughout. Implicitly, all higher

percentiles also achieve the maximum distribution. In the RMI case, there are a variety of

different outcomes in the 5th- to 25th-percentile range, with many failing to meet the tar-

get.

128. Under the moving adjustment rule (MAR), distributions start out at $26 million.

Along the fifth-percentile trajectory, distributions decline gradually to $15 million by

FY2050 because the drawdowns are reduced when the CTF corpus is below sustainable

levels. Along the 50th-percentile trajectory, all outcomes attain the target distribution.

The MAR trajectories indicate improvement over COFA.

129. Under the sustainability rule (SR), all of the percentiles between 5 and 95 lie

along one single line. Distributions fall to $21 million in FY2024, reflecting the median

starting point, and from that point on they remain at that level. This is guaranteed by the

rules inherent in SR. While there is a large (19 percent) adjustment in FY2024, from that

point on distributions can be relied upon by design to remain at that level through the

specification of the rule.

130. The SAFER rule combines MAR and SR, and distributions also start at $21 mil-

lion, but distributions are allowed to rise once the corpus has attained twice the primary

target. At the fifth-percentile level, distributions follow the SR case, but from FY2037

there is a decline by a small amount, reflecting poor market performance. Under SAFER,

upward adjustment is only allowed once the corpus has attained a safe level, and thus re-

duced distributions only occur in rare cases. In the vast majority of percentiles, distribu-

tions rise through the period.


$0

$5

$10

$15

$20

$25

$30

$35



5-50% of cases

$0

$5

$10

$15

$20

$25

$30

$35

Sustainability rule



$0

$5

$10

$15

$20

$25

$30

$35

COFA rules

5-25% of cases



F. COFA plus SAFER

131. The question naturally arises from the above discussion as to whether a better re-

sult could be obtained through combining the SAFER and COFA rules—in other words,

adopting a distribution policy that limits distributions in FY2024, as prescribed under SR,

and allowing adjustment for tail risk thereafter, as specified under SAFER. The ad-

vantage of this approach would be that it entails no requirement for a change in law by

the US Congress. Table 9 provides the results. Clearly, the results of the comparison of

the hybrid of COFA plus SAFER to SAFER alone are close, but with SAFER scoring

five percentage points above the hybrid. However, there is one critical difference: that of

zero distributions. While the odds of a zero distribution in at least one year during the dis-

tribution period are zero under SAFER, they persistently remain significant, at 23 per-

cent, under the hybrid. This results directly from the overriding requirement to protect the

nominal value of the corpus under COFA. While this suggests that attempts to modify the

CTF rules should be pursued, the hybrid does provide a distribution policy if changes in

law are not feasible.

G. Increasing Contributions

132. From the foregoing analysis, it is clear the prospects for the RMI economy in the

post-amended-Compact period without remedial action will be subject to significant risk.

While the last section indicates that rules can be found that result in a less volatile out-

come than the COFA rules, both sets are likely to result in significant reductions in reve-

nues to support the daily operations of government. The implications, in an economy

with a tiny private sector unable to compensate for declining Compact grants, are fiscal

adjustment, reduced economic output, and migration to the United States and its territo-

ries. Clearly, the CTF will not perform its objectives unless additional funding is found.

Figure 23 Comparison of distributions under the different rules, $’s millions

$0

$5

$10

$15

$20

$25

$30

$35

SAFER


5-50% of cases

50-95% of cases


133. In this section, it is assumed that the RMI is able to supplement the annual US

contributions to the CTF through FY2023 out of the emerging government structural fis-

cal surplus discussed in the FY2016 RMI economic review.1 In chapter V of the eco-

nomic review, under the fiscal-responsibility scenario, projections of the RMI economy

are made through FY2023. Under this scenario, it is assumed the RMI has sufficient fis-

cal space to contribute $5 million in FY2019, inflation adjusted through FY2023. An ini-

tial contribution to the CTF of $13 million, the projected value of the existing D account

(not included in the above base simulations), is assumed in FY2018.


FY2023 with additional RMI contributions. In comparison to Figure 16 (without RMI

contributions), the probability of achieving the primary target in FY2023 increases from

87 to 91 percent. The median value also rises, from $715 to $763 million, an important 7

percent increase given the relatively modest additional contributions.

135. A variety of alternative investment strategies for the RMI funds present them-

selves going forward. We consider three:

1. COFA++: RMI resources are used to augment the existing COFA Trust Fund.

1 The Graduate School USA, Republic of the Marshall Islands Fiscal Year 2016 Economic Re-

view, 2017, Honolulu, HI.

Table 10 RMI Compact Trust Fund simulations: running COFA under SAFER

Simulations

Performance Measures COFACOFA plus

SAFERSAFER Rule







Volatitity results




COFA and SAFER


2. SAFER++: both the CTF and RMI resources are comingled in a new joint US

RMI fund requiring US congressional amendment to the existing agreement.

3. RMI Buffer: RMI resources are maintained in a separate fund and used to supple-

ment distributional shortfalls when experienced, but otherwise accumulate in the

local fund.

i COFA++

136. Table 10 provides an indication of the standard results. As expected, COFA++

with the additional funding reveals similar results to the existing smaller COFA fund. The

outcome is favorable in terms of maintaining fund levels and distributions but remains

woefully inadequate in terms of volatility. The probability of a zero distribution during

the drawdown phase falls from the 35 percent under the unaugmented COFA fund to 30

percent in the joint, still unacceptably high and fiscally unmanageable. The overall score

of the performance indicator improves to 88 percent. Further simulations, not reported

here, indicate that these results are not significantly improved even with very large addi-

tional infusion of funds. The existing CTF arrangements are deeply flawed.

ii SAFER++

137. Under the SAFER++ simulation, it is assumed that the CTF subsidiary agreement

is amended by the US Congress and the revised regime permits the implementation of the

SAFER rule. US contributions and RMI resources contribute to a new CTF during the ac-

cumulation phase. In FY2024, the SAFER rule is implemented, and a new distribution is

determined based on maintaining a sustainable fund corpus thereafter. Given the level of

Figure 24 Probability Distribution of the Compact Trust Fund with RMI Contributions, $’mil-

lions

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

4.5%

$0 $500 $1,000 $1,500 $2,000

Median value = $763m;40% above primary targetPrimary target

= $544m;91% chance of attainment


resources projected in FY2023, this will imply a reduced distribution. To make up the

loss, the RMI national-government surplus ($5 million in FY2019, inflation adjusted) is

first drawn on to make up the shortfall, and any residual funds are directed back into the

CTF. This process continues until the CTF corpus achieves a level twice that based on the

primary target, when further RMI contributions cease. However, these transfers are re-

quired for some considerable time. The median number of years that elapse before this

requirement is met is six years—that is, up through FY2030—and by FY2050 the proba-

bility of the need for continuing contributions remains large at 36 percent.

138. Table 10 indicates that while the probability of the real level of the CTF in

FY2050 exceeding the FY2023 level under SAFER++ is lower than under COFA++, the

probability of attaining the target distribution in FY2050 has improved. The average dis-

tribution of SAFER++ over the period is an improvement and reaches 98 percent, alt-

hough that of attaining the target in FY2050 falls. Most importantly, volatility is elimi-

nated. The overall level of the performance indicator reaches 93.7 percent and clearly

surpasses that of COFA++.

iii RMI Buffer

139. The RMI buffer trust fund is exceptionally simple: all of the allotted RMI na-

tional-government fiscal surplus is allocated to an RMI trust fund. In FY2024 and on-

ward, when there is a shortfall in the distribution from the COFA component, sufficient

funds are transferred from the RMI fund to make up the shortfall. This process continues

until two conditions hold: (i) the combined CTF and RMITF corpus achieves a level

twice that of the primary target, and (ii) the level of the RMITF has attained five times

Table 11 Augmenting trust fund resources: performance results

Simulations

Performance Measures COFA ++ SAFER ++ RMI buffer







Volatitity results




Additional RMI Contributions


the target distribution. At this point, further RMI contributions cease. Table 10 indicates

that this approach provides the highest score of the performance indicator, reaching 94.5

percent. While the level of the combined corpus does not achieve that of the other funds,

distributions are nearly always on target and volatility is largely eliminated.

140. Table 10 indicates the overall result of RMI buffer is slightly superior to

SAFER++, although the two outcomes are very similar and the results are not statistically

different. However, there are other considerations. While the RMI-buffer approach is

simple and does not require congressional action, greater inspection of the data reveals

that in the lower percentiles, the buffer option has a greater tendency to collapse than

SAFER++. This can be inferred from Table 10, which indicates that SAFER++ has a

score that is higher on the fund corpus but lower on distributions, which indicates longer-

term sustainability. This report favors SAFER++, but SAFER++ comes at the cost of re-

quiring congressional action.

iv Graphical Comparison

141. Figure 25 provides a graphical representation of the results in this section to aid

understanding of the operation of the different rules. COFA++ with the additional funds

indicates three bands of distributions. In the worst case, along the zero-percentile line,

distributions quickly drop to zero and remain at that level. Along the fifth-percentile line,

distributions hold at the maximum for a few years, then drop off till hitting $13 million in

FY2050. Along the 10th-percentile line, matters are significantly improved, but small re-

ductions are required from FY2043 onward. Only along the 15th-percentile line are full

distributions achieved.

142. The simulations under SAFER++ indicate a more acceptable outcome: zero and

disastrously low outcomes are avoided. In the worst case, distributions average $10 to

$15 million, while along the fifth-percentile line, distributions are always above $20 mil-

lion. In the 5th- to 25th-percentile band, the vast majority of distributions are above $20

0.0

5.0

10.0

15.0

20.0

25.0

30.0


5-10% of cases

0-5% of cases

10-15% of cases

COFA++


million, and in the best 25–50 percent of cases, small reductions in distributions are only

required in rare cases. Above the 50th-percentile level, target distributions are achieved.

143. In the RMI-buffer simulation, only in the band from zero to the fifth percentile are

distributions less than target, and in the worst cases distributions drop to $5 million, the

annual contribution from the RMI to supplement CTF shortfalls. Comparing the two low-

est bands of RMI buffer and SAFER++ suggests that some reduction in distributions un-

der SAFER++ is preferable to the larger fiscal-shock potential under the worst-case sce-

narios under buffer. However, in the higher percentiles, RMI buffer would be preferred.

0.0

5.0

10.0

15.0

20.0

25.0

30.0

35.0 Amendied Compact distributions in FY23 prices

0-5% of cases

5-25% of cases

SAFER ++

Figure 25 Comparison of distributions under different RMI contribu-

tion regimes

0.0

5.0

10.0

15.0

20.0

25.0

30.0


0-5% of cases

5-100% of cases meet target

RMI buffer


v Conclusion

144. The results of the simulations involving additional RMI contributions indicate that

the RMI can have a real impact toward establishing a sustainable fiscal environment for

the future, although the need for fiscal adjustment remains. The overall results of

SAFER++ and the RMI buffer are largely indistinguishable, although SAFER++ displays

greater long-term sustainability. The better results obtained through additional RMI con-

tributions and adoption of a rule such as RMI buffer should not discourage attempts to

amend the CTF Agreement. The RMI contributions proposed in this paper, while entirely

feasible, are yet to be adopted in the RMI. Failure to reform the CTF Agreement runs the

risk that the additional RMI contributions are not forthcoming and the nation is forced

into a highly volatile fiscal environment.

67

V. THE ROP TRUST FUND

A. Compact Trust Fund Performance (Analysis Based on Data through FY2017)

1. BACKGROUND

145. In comparison to its sister Freely Associated States, the Republic of Palau negoti-

ated a significantly different economic-assistance component under its Compact of Free

Association. An important feature was the Compact Trust Fund (CTF), which had the

mutually agreed objective of providing $5 million annually from FY1999 to FY2009 and

then $15 million annually for Palau’s government operations through FY2044 (the end of

the 50-year period of the Compact). For reasons difficult to discern, the assumed rate of

return for the CTF was 12.5 percent annually. This assumption was surely influenced by

the high interest rates prevailing at the time of the original negotiations; however, by the

time the CTF was actually invested in February 1995, such a sustained rate of return over

an extended period was clearly going to be difficult—if not impossible—to achieve using

a prudent investment policy. As it turns out, and as described below, the CTF has per-

formed satisfactorily relative to US market benchmarks for stock and bond returns during

the 14 years and 8 months from February 1995 through the end of FY2009 and the 22

years and 8 months through the end of FY2017.

146. This review will not comment extensively on the governance of the CTF. How-

ever, it should be noted that the management of the fund has clearly been consistent with

the Compact and subsidiary-agreement requirements, with the possible exception that

oversight and reporting to the US government has been less robust than was anticipated.

For most of its life, the CTF has been managed by a board of trustees, under ROP statu-

tory authority, that set the initial investment policy and enacted modifications of that pol-

icy on three subsequent occasions, as detailed below. For the seven years through mid-

FY2014, the management was more or less by an ad hoc committee made up of the min-

ister of finance and the chairs of the relevant committees in the House and Senate of the

OEK. Since mid-FY2014, the CTF has once again come under a statutory board-govern-

ance mechanism. This seems appropriate when considering the following two factors: (i)

the relative importance of the CTF to Palau’s future fiscal stability; and (ii) concern about

the lack of transparency of certain withdrawals made in FY2011 and FY2012. Those

withdrawals exceeded the Compact-restricted level ($5 million annually) by $2 million in

each year. While Palau had restored the excess withdrawals as of the second quarter of

FY2013, there was clearly a need for greater transparency and improved control mecha-

nisms in the day-to-day management and broader investment-policy oversight of the

CTF.

147. Starting in January 2014, the CTF Advisory Committee revised the Investment

Policy Statement, and this was further revised and officially confirmed by the CTF Com-

mittee in April 2014. The four separate strategic asset allocations that have been in place


from the outset are detailed in the authors’ recent annual economic reviews.1 It should be

noted that the transition to the new investment strategy, including a shift from the invest-

ment advisory and custody arrangements that prevailed from the outset through early

2014, is deemed for the purposes of this review to have started on April 1, 2014. In fact,

the transition began as early as February 2014 and was not fully implemented until June

1, 2014.

2. CTF PERFORMANCE

148. Switching to a review of CTF performance, Figure 26 shows the projected values

using the originally projected investment rate of return of 12.5 percent, juxtaposed with

the actual results through both FY2009 and FY2017. Over the 22.67-year period, the ac-

tual final value through the end of FY2017 of $219.8 million reflects a growth rate of 7.8

percent annually.

149. As of the end of the initial 15-year period (the end of FY2009), the trust fund

value of $144 million reflected an average rate of growth of 7.47 percent from invest-

ments starting in February 1995. However, that value was far below the original $285

million value assumed by the Compact. This is despite the fact that over that initial period

through FY2009, the Palau CTF performance exceeded index performance: 7.47 percent

actual growth versus 7.32 percent for the cost-free market-index benchmark for the CTF.

It should be noted that Palau prudently chose not to withdraw Compact-allowed amounts

of $5 million annually for the four years from FY1999 through FY2002. Without Palau’s

1 The Graduate School USA, Federated States of Micronesia Fiscal Year 2016 Economic Review,

2016, Honolulu, HI.

Figure 26 Original projected CTF values –vs– actual, FY2001-FY2015 (4/30/15)

$120

$140

$160

$180

$200

$220

$240

$260

$280

$300

us

$millions

$285mPROJECTED AT 12.5% to end FY2009

$219.8mEND OF FY2017

$144mEND OF FY2009

The RoP Compact Trust Fund 69

admirable forbearance, the shortfall of the CTF in comparison to assumptions would have

been significantly greater.

3. LOOKING FORWARD: THE IMPORTANCE OF THE COMPACT REVIEW

AGREEMENT

150. The CTF featured prominently in the Compact Review undertaken by the US and

Palau following the end of the 15th year of the Compact. Specifically, section 432 calls

for reviews at the 15th, 30th and 40th anniversaries of the Compact. The first review was

concluded with the signing of an agreement, in September 2010, to renew the economic-

assistance terms of the Compact for the 15-year period from FY2010 through FY2024. In

recognition of the perceived likelihood that the CTF would not assuredly achieve its ob-

jective of providing $15 million of annual funding to the government of Palau through

FY2044 (the 50th year), substantial changes were built into the agreement for both the

supplemental funding of the CTF and for reducing the pace of withdrawals that would

otherwise have been taken from the CTF.

151. Figure 27 shows the nature of the projections that were reviewed after FY2009

with respect to the CTF. If the end-of-FY2009 balance of $144 million had been drawn

upon as originally anticipated at $15 million annually starting in FY2010, without any

sort of accommodation resulting from the section 432 review, then the results were pro-

jected to be dismal. As shown, if the trust fund had delivered returns of 5.5 percent annu-

ally, failure would have occurred just prior to FY2022, long before the mutually agreed

goal of funding through FY204, and even before the next scheduled section 432 review

after the 30th anniversary of the Compact at the end of FY2024.

Figure 27 COFA TF projection at 5.5% from FY2009, pre-Section 432 Compact Review

$0

$20

$40

$60

$80

$100

$120

$140

$160

us

$millions

TF Value $144mEND OF 15th YEAR

Projected FailureIN FY22 AT 5.5% ANNUAL GROWTH


152. Together with other results agreed upon through the section 432 Compact Review

process, there was an agreement to “shore up” the CTF so that it would have a much

stronger chance of performing through FY2044, as agreed in the original Compact. With

respect to strengthening the trust fund, an important methodological agreement was

reached between the US government and RoP officials. It was agreed that the earlier mis-

take of choosing an assumed investment rate of return that was inordinately high would

be avoided. Specifically, it was agreed to use a 5.5 percent (net) investment rate of return

for all projections guiding the review. As shown in Figure 27, that alone would not have

been sufficient. So, in addition, it was agreed that a portion of new (annual) funding

would be dedicated to the CTF. Furthermore, a substantial, though declining, flow of an-

nual economic assistance was agreed to be provided, thereby enabling Palau to reduce its

annual withdrawal rate from the trust fund. These factors combined to allow for both

more reliable and more successful forward projections of the likely ability of the CTF to

achieve the agreed-upon objectives through FY2044.

153. Figure 28 shows two scenarios that indicate the importance of achieving mutual

agreement to implement the now-funded section 432 Compact Review Agreement. In the

unlikely circumstance of failing to achieve mutual agreement, the projected results are

notably better than had been projected as of FY2010; however, the results remain disap-

pointing. Recent market performance, reflecting recovery after the nadir of the trust fund

during FY2009, allows for the trust fund to likely survive longer at a 5.5 percent growth

rate than had been projected at the time of the section 432 review. By the end of FY2024,

in advance of the second section 432 Compact Review, the trust fund balance would have

shrunk to a projected $189 million and would have been on pace to fail during FY2044,

having fallen just short of the original goal.

154. With reason for optimism, Figure 28 also projects the value of the CTF under the

assumption that mutual agreement is readily achieved and the agreement in modified

Figure 28 CTF projections with and without approved review agreement, FY2015-FY2044 (year 50 of COFA)

$0

$50

$100

$150

$200

$250

$300

us

$millions $229.3m

WITH AGREEMENT IN FY19(END OF 50th YEAR AT 5.5% GROWTH)

Projected FailureWITHOUT AGREEMENT

FY44 AT 5.5% ANNUAL GROWTH


form is implemented at the outset of FY2019. At the agreed projected growth rate of 5.5

percent, this scenario allows for fully achieving the objective of funding Palau for speci-

fied government operations through FY2044. With a projected balance at that date that

was just over $229 million but declining, the CTF would be projected to fail about 29

years after the end of the 50-year Compact period. As noted below in this chapter, such a

possibility enables the RoP to consider setting as a goal the transformation of the sinking

CTF to a perpetual CTF. While there are other measures of importance awaiting approval

of the agreement, such as funding for infrastructure projects and maintenance, the suc-

cessful shoring up of the trust fund is surely the most important outcome to support Pa-

lau’s fiscal stability and economic security going forward.

155. In the following section, a more sophisticated, risk-inclusive form of analysis is

used to analyze the range of outcomes that might prevail given the volatility of market re-

turns and the uncertainty of the sequence of those returns over time.


156. This section of the study is forward looking and simulates performance and ability

to achieve the CTF principles outlined in chapter II over the remaining renewed Compact

and the drawdown period after FY2024. The simulations use Monte Carlo analysis, and

the method is described in more detail in appendix 1. Under the COFA simulations, it is

assumed the renewed Compact is implemented in FY2019. Two variants are examined:

(i) drawdowns are fixed in nominal terms ($15 million), and (ii) drawdowns are inflation

adjusted. Under the renewed Compact, it is assumed that the terms of the renegotiated

agreement are honored subject to the March 2018 US authorization and appropriations

bill; the estimated revised schedule is depicted in Table 11. However, since there have

been no contributions to the trust fund to date, it is assumed that a $24 million back pay-

ment is made in FY2019 and that further annual contributions continue as planned

through FY2023, such that total US contributions remain the same as in the original re-

newed Compact Agreement. Drawdowns from the CTF revert in FY2019 to the negoti-

ated levels. While having no impact on CTF performance, annual US operational grants

are also assumed to revert to the negotiated levels.

157. Figure 29 provides a depiction of the simulated CTF value at the end of the re-

newed Compact period, FY2024. It indicates that from a current value in FY2017 of $220

million, the fund is likely to attain a value of $317 million in FY2024 (the median simu-

lated value). However, the probability of the CTF attaining the level of the primary target

is 54 percent. Further, it must be borne in mind that the primary target is only a bench-

mark and is based on a risk-free assumption. Figure 29 thus indicates that the likely level

of the CTF in FY2024 may well be below a level required to provide a sustainable yield

to support current levels of government operations in the RoP thereafter.

158. Table 12 provides statistics based on the performance criteria defined above for

the set of simulations undertaken in this review during the FY2025–FY2044 period. Fo-

cusing on the results for the renewed Compact without inflation adjustment, the measure


Figure 29 Probability Distribution of RoP Compact Trust Fund in FY2024,

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

$0m $100m $200m $300m $400m $500m $600m $700m $800m

Median value = $317 million

Primary target= $301 million54% chance of attainment

Table 12 Estimated renewed Compact schedule of contributions and drawdowns

* An apparent “offset” of 5.926 million is herein applied to section 2(a) funding; this remains subject to mu-

tual agreement. ** Excludes $9.0 million for US Postal Service, FY2019-2024.

(1)

Section 1

211(f)

CTF

Supplement

(2)

Section 2(a)

Infrastructure*

Maintenance

Fund

(3)

Section 3

Fiscal

Consolidation

(4)

Section 5

Infrastructure

Projects

(5)

Section 4(a)

Direct

Economic

Assistance

(6)

Section 4(b)

RoP Draw

from

CTF (max)

(5+6)

Funding

for RoP

Budgetary

Support

(Sum of 1-5)

Total US

Contributon

(excludes

US Postal)

FY10 13.147 5.000 18.147

FY11 13.147 5.000 18.147

FY12 13.147 5.000 18.147

FY13 13.147 5.000 18.147

FY14 13.147 5.000 18.147

FY15 13.147 5.000 18.147

FY16 13.147 5.000 18.147

FY17 13.147 5.000 18.147

FY18 13.147 5.000 18.147

FY19 24.000 12.074 10.000 40.000 6.000 10.000 16.000

FY20 2.000 2.000 5.000 10.500 15.500

FY21 2.000 2.000 4.000 11.000 15.000

FY22 2.000 2.000 3.000 12.000 15.000

FY23 0.250 2.000 2.000 13.000 15.000

FY24 2.000 15.000 15.000

Agreement

total**: 30.250 22.074 10.000 40.000 138.323 240.647


for protecting the corpus, the probability of maintaining the real value of the corpus be-

tween FY2025 and FY2044 is 65 percent. The chance of the CTF being above the pri-

mary-target value in FY2044 is 66 percent, an improvement over the probability of 54

percent of attaining the primary target in FY2024. All of these measures are in relative

proximity, indicating the sustainability of the corpus remains little changed through the

period.

159. The second section of Table 12 further indicates the nature of the annual distribu-

tions that can be anticipated after FY2024. In terms of attaining the target drawdown

level, defined as the inflation-adjusted equivalent of the $15 million, the average draw-

down over the period is 82 percent, and the probability of attaining the target in FY2044

is 65 percent. In terms of fund collapse, there is a 4 percent chance that the CTF will be-

come exhausted during the period. Finally, the overall performance rating of the CTF un-

der the renewed Compact framework is 78 percent. On its own, this benchmark has little

value without comparison to the alternative simulations, which are discussed below.

160. For further illumination, Figure 30 indicates the number of cases of achieving real

annual drawdowns in selected ranges. The graph indicates that in FY2025, all simulations

attain the target distribution of $15 million. In FY2030, distributions have fallen in real

value (by the rate of inflation) because distributions are set in nominal values, but in

nearly all cases this level is attained. As time progresses, inflation continues to erode the

annual real level of distributions, but also the number of zero distributions and hence the

number of occurrences of fund collapse rise. By FY2044, the number of fund collapses

has reached 4 percent and the value of the annual distributions has fallen by 48 percent.

Table 13 RoP Compact Trust Fund simulated results and performance under the COFA rules

Simulations

Compact Trust Fund Corpus resultsRenewed

Compact

Real

Drawdown =

$15m

Probability of real CTF in FY44 > the FY25 value 64.9% 55.3%

Probability of real CTF value > the Primary Target in FY44 66.0% 58.1%


Average distribution through FY25-FY44 % target 82.0% 98.0%

Proabability of attaining target distribution in FY44 64.8% 91.5%

CTF Collapse

Probability of fund collapse by FY44 4.0% 9.2%

Overall Performance Rating 78.3% 80.7%

COFA Rules

Renewed Compact


161. Under the second set of simulations displayed in Table 12, the results indicate the

outcome if the RoP is allowed to draw down the $15 million (inflation adjusted) from

FY2024. Under this scenario, the RoP avoids the need for annual fiscal adjustments. The

CTF corpus falls relative to the baseline case without inflation adjustment, but average

distributions are improved significantly. However, this is offset by an increased chance of

fund collapse to 9 percent over the 20-year drawdown period. Overall, the combined per-

formance indicator attains 81 percent, better than the base case with no inflation adjust-

ment. This result is obtained through limiting the horizon to FY2044. As the horizon is

extended, the probability of fund collapse increases, and the overall performance indica-

tor declines compared with the base case of no inflation adjustment. In effect, maintain-

ing real distributions favors current generations at the expense of future generations.

C. Moving Adjustment Rule

162. In this section, an alternative rule is deliberately designed to adjust the level of

drawdown to the value of the fund corpus. In the MAR case, it is assumed a downward

adjustment, or decrement, of 5 percent of the previous year’s distribution will be made if

a five-year moving average of the CTF value falls below the primary target.1 Downward


tio of the actual CTF value to primary target). At this point, an upward adjustment, or in-

crement, of 2 percent is made. Adjustment is thus asymmetric: on the downside, adjust-

ment is more rapid, and on the upswing, adjustment is slower in order to allow the CTF

1 See appendix 1 for full specification of the moving adjustment rule.

Figure 30 Distributions by number of cases falling in selected ranges under the Renewed Com-

pact

-

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

10,000

2025 2030 2035 2040 2044


to return more rapidly to the primary target. On the upside, when the CTF value exceeds

the primary target there is no allowance for venting. However, some adjustments to the

CTF may be desirable in those circumstances in which the fund grows very large.

163. The starting position and median value of the CTF in FY2024 is the same as un-

der the COFA set of rules. Referring to Table 13, the basic metrics for the MAR simula-

tions are provided. In terms of sustaining the CTF corpus, and in comparison with the

COFA real variant, the MAR rules show improvement (comparison with the real draw-

down variant is adopted in this and subsequent sections). The probability of maintaining

the real value of the CTF over the FY2025–FY2044 period is 66 percent, compared with

55 percent for COFA. Similarly, the probability of the CTF being above the primary tar-

get in FY2044 is 66 percent and the probability of being above the real drawdown under

the COFA rule is 58 percent. Clearly, since MAR reduces distributions when the corpus

dips below the primary target, it should be anticipated that MAR shows improvement in

maintaining the value of the fund.

164. In terms of achieving the target distributions, the outcome as expected will see a

deterioration compared with COFA; the average distribution over the period drops from

98 percent under COFA to 88 percent under MAR, and the average distribution in

FY2044 drops from 92 percent to 85 percent. In terms of fund collapse, there is a signifi-

cant improvement, with the probability of collapse during the period falling from 9 per-

cent to 0 percent. In effect, the annual adjustment under MAR, responding to weak CTF

performance, protects the corpus and avoids fund collapse. Overall, the MAR rule shows

an increase in performance to 84 percent compared with 81 percent under COFA. This is

an improvement reflecting that the moving adjustment process protects the value of the

corpus and the interests of future generations.

Table 14 RoP Compact Trust Fund simulated results and performance under alternative rules

Simulations RoP++


Real

Drawdown =

$15m

Moving

Adjustment

Rule

Sustainability

RuleSafer Rule

2.5% of GDP

Revenue

Effort

Probability of real CTF in FY44 > the FY25 value 55.3% 65.5% 81.7% 79.9% 88.1%

Probability of real CTF value > the Primary Target in FY44 58.1% 65.8% 81.7% 79.5% 92.2%


Average distribution through FY25-FY44 % target 98.0% 88.4% 65.1% 74.9% 99.9%

Proabability of attaining target distribution in FY44 91.5% 85.1% 65.1% 84.1% 99.9%

CTF Collapse

Probability of fund collapse by FY44 9.2% 0.4% 0.0% 0.0% 0.0%

Overall Performance Rating 80.7% 84.0% 82.3% 86.4% 96.7%

COFA Rules

Renewed

Compact

Alternative Rules


165. Figure 31 (the comparison to Figure 30) presents the number of cases, or proba-

bility distribution, of drawdowns falling in five selected yearly intervals. In FY2025, the

majority of cases—5,657 (i.e., 57 percent)—produce a distribution at the target value,

and 33 percent fall in the $12 to $14 million range, with decreasing numbers in the lower

ranges. As time progress, there are similar levels of cases that hit the target, but greater

numbers spread out in the lower ranges. There are a negligible number of cases reflecting

fund collapse, 0.4 percent.











mary target. In this section, we first simulate SR on its own and then augment it with



Figure 31 Distributions by number of cases falling in selected ranges under the Moving Aver-

age Rule (MAR)

-

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

10,0002025 2030 2035 2040 2044





fined SR primary target. SR distributions are based on multiplication of the estimated real

geometric portfolio yield by the SR primary target. The SR target distribution is thus





168. Under SR, the median drawdown in FY2025 is $9.5 million, or 37 percent of the

target rate of $15 million, which implies an immediate fiscal adjustment of $5.5 million.

The adjustment differs from that under MAR, which involves a gradual adjustment re-

sponding to CTF performance. SR fixes an inflation-adjusted distribution in FY2025 and

thereafter and allows for no variation once the initial adjustment has been completed.

169. The results of simulating CTF performance under SR are shown in Table 12.

Comparisons are again made with the COFA real drawdown rule and MAR. SR performs

best of the three rules in terms of protecting the CTF corpus. The percentage of cases in

which the CTF’s real value in FY2044 is above the FY2025 value rises from 55 percent

under COFA to 66 percent under MAR and is 82 percent under SR. In the case of distri-

butions, the results work in the opposite direction. The average distribution over the pe-

riod as a percentage of the target falls from 98 percent under COFA to 88 percent under

MAR to 65 percent under SR. SR eliminates fund collapse during the period better than

MAR and is a significant improvement over COFA. Overall, the score of SR is not as fa-

vorable as that of MAR.

170. The number of cases of achieving given levels of annual drawdowns under the

sustainability rule for selected years is indicated in Figure 32 (see Figure 30 and Figure

31 for comparison). The first thing to notice is that the probability functions for the se-

lected years are identical, unlike under COFA or MAR, which are significantly different

from SR. This follows from the adoption of a given distribution in FY2025, which will

remain at that level in real terms thereafter unless the CTF collapses. In comparison to

MAR, the simulations for SR indicate a predictable future path, albeit with a large initial

reduction in drawdown.


(SAFER)









vided. The starting position is the same as under COFA, MAR and SR with the corpus at-

taining a median value of $317 million. As a general observation, the COFA rules pro-

vide results at the extremes: best in terms of distributions, but worst in terms of protecting

the corpus and avoiding fund collapse. The SAFER rule generally produces results that

lie between MAR and SR. SAFER does better than MAR but not as well as SR in pro-

tecting the fund corpus and vice versa for distributions. The results of all three are similar

in terms of avoiding fund collapse. SAFER produces the best result so far in terms of

overall performance: 86 percent.

173. Figure 33 provides an illustration of the results in comparison to COFA, MAR

and SR (see Figure 30, Figure 31 and Figure 32 for comparison). The position in FY2024

is identical to that under SR, although not as favorable as under MAR. However, as time

progresses and the corpus accumulates (since the drawdown rate is below the long-term

estimated geometric portfolio yield), enhanced distributions are allowed. As in the case of

SR, a large number of distributions lie in the $6 to $12 million range, reflecting the initial

reduction to a sustainable level, a level at which they remain for some time before en-

hanced distributions occur. However, under SAFER there are an increasing number of

distributions at the target, reflecting the upward adjustment possible under SAFER, a

number that grows over time. In the case of SR, there is no improvement over time as

distributions are designed to remain stationary.

Figure 32 Distributions by number of cases falling in selected ranges under the Sustainability

Rule (SR)

-

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

10,0002025 2030 2035 2040 2044


174. The adoption of the SAFER rule thus indicates that an improved result can be

achieved over time through the adoption of well-designed rules and without additional

funding. Clearly, the SAFER rule favors future generations in terms of protecting the

CTF corpus and avoids fund collapse. This is achieved, however, through a reduction in

annual drawdowns. While SAFER gives the best result so far, distributions are less than

target, and overall the performance score is less than the objective of 95 percent.

E. Increasing Revenue Effort: The RoP++ Rule

175. In the case of the FSM and RMI, the large structural fiscal surpluses being experi-

enced provide a source of funds to augment CTF shortfalls and sterilize the windfalls

from contributing to expenditure growth. As a result, a better CTF performance score is

achieved. In the case of the RoP, the increase in fishing fees is not nearly as large and the

creation of the marine sanctuary places uncertainty over reliance on this source of reve-

nues. The RoP FY2016 economic review1 presents a reform strategy including imple-

mentation of revenue-neutral tax reforms. The RoP strategy did not propose that the tax

reforms should initially be used to augment the Palau CTF. However, in this scenario we

examine the case in which the RoP reactivates the tax-reform strategy and uses its in-

creased revenue powers to generate a revenue effort of 2.5 percent of GDP.

176. The increased revenue effort is projected to yield $7.2 million in FY2018 and to

rise thereafter with inflation; no allowance is given for economic growth, which would

1 See the FY2016 RoP economic review for further details on the tax-reform strategy.

Figure 33 Distributions by number of cases falling in selected ranges under the SAFER Rule

-

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

10,000

2025 2030 2035 2040 2044


enhance revenue effort in the long term. The additional revenue effort is used to augment

the CTF in the shoring-up phase through FY2024. After this time, it is assumed that the

continuing resources are first allocated to any CTF drawdown shortfall to support govern-

ment operations but that thereafter the remaining surplus continues to augment the CTF

until the size of the fund reaches twice the size of the primary target. This rule is known

as RoP++. The simulations are based on the assumption that implementing the SAFER

rules generates the highest score under the performance indicator.


FY2024 with additional RoP contributions. In comparison to Figure 29 (without RoP

contributions), the probability of achieving the primary target in FY2024 increases from

54 to 77 percent. The median value also rises from $317 to $376 million, a significant 19

percent increase. Referring to Table 12, the probability of an increase in the real CTF

value over the period rises to 88 percent. In the case of the objective of maintaining the

annual distributions, the average distribution hits 100 percent of target and the probability

of attaining the target in FY2044 alone is also 100 percent. As expected, the results indi-

cate fund collapse has been eliminated. An overall performance rating of 97 percent is

achieved, above the 95 percent target.

178. To complete the story, in comparison to the earlier simulations, Figure 35 indi-

cates the number of cases of distributions that fall into the selected ranges under RoP++

at five yearly intervals. The figure indicates that distributions meet the target in over 95

Figure 34 Probability Distribution of the Compact Trust Fund with RoP contributions

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

4.5%

$0m $100m $200m $300m $400m $500m $600m $700m $800m

Median value = $376 million

Primary target= $301 million77% chance of attainment


percent of cases in all the years selected. In fact, the performance in each of the selected

years is almost identical.

179. The projections on which this result is based have assumed a revenue effort

equivalent to 2.5 percent of GDP. After several years of inactivity, the tax-reform initia-

tive is now actively being reconsidered. The simulations conducted in this review indi-

cate the level of revenue effort necessary to resolve the structural fiscal deficit facing the

RoP resulting from CTF inadequacy. The RoP++ simulations suggest that a revenue ef-

fort of 2.5 percent of GDP to shore up the CTF will resolve this issue.

F. Comparison of the Different Rules

180. Finally, we compare the performance of the annual distributions under the differ-

ent rules. Under each rule, it is assumed that the CTF corpus attains a value in FY2025

equal to the median value under the COFA rules; the starting point is thus identical under

each rule. In reality, of course, the starting point in FY2025 will reflect market perfor-

mance between the current position and FY2025. The bands of annual distributions

shown in Figure 36 reflect groupings lying between selected percentiles of the simulation

outcomes. The upper tail of the distribution greater than 95 percent is not shown.

181. The first case in Figure 36 is the COFA case with inflation adjustment, and it indi-

cates an apparently very favorable result: within the 5th- to 95th-percentile band, all dis-

tributions provide the target inflation-adjusted distribution of $15 million in FY2025 val-

ues. However, this rosy outcome is not reflected within the range from zero to the fifth

percentile, and in FY2035 the fund collapses along the first or zero percentile line. Fur-

Figure 35 Distributions by number of cases falling in selected ranges under RoP++

-

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

10,0002025 2030 2035 2040 2044


ther insight into this result is provided in the second graphic, which provides the proba-

bility distribution of the COFA corpus. Along the 50th-percentile trajectory, the real

value of the CTF is maintained. However, below this line, COFA values are projected to

decline and the CTF is almost exhausted along the 5th-percentile case by FY2044. Below

this range, the COFA fund collapses in most cases. For the RoP, the issue is intergenera-

tional: if there is no concern for future generations after the Compact, then the existing

arrangements are fine, but if the wellbeing of future generations is important, then reme-

dial action is required.

182. Under the moving adjustment rule (MAR), there is no need for an adjustment in

FY2025, as the median value of the corpus of $317 million is above the primary target of

$301 million. From this point forward, no adjustment is required in the higher percentiles

(50–100). However, below this range, adjustment is required in some cases in that the

COFA corpus dips below the primary target. By FY2044, along the fifth-percentile line,

distributions have fallen to $7.5 million, and in a few cases the fund collapses. While this

result looks less favorable than that under the existing COFA rules, the MAR rule is bi-

ased to favor protection of the corpus and future generations.

183. Under the sustainability rule (SR), distributions fall to $9.5 million in FY2025, re-

flecting that the median starting point is below the level of the primary target multiplied

by the sustainability adjustor. While there is a large (37 percent) adjustment in FY2025,

from that point on distributions remain at that level through the specification of the rule,

unless the fund collapses. As Figure 36 indicates, this only happens in the zero- to fifth-

percentile range and at the close of the period. The adjustment required in FY2025 in fact

indicates the fiscal gap facing Palau. It is the degree of adjustment required to make up

for the underfunding of the fund corpus.

184. The SAFER rule combines MAR and SR. Distributions also start at $9.5 million,

but are allowed to rise once the corpus has attained the threshold level. At the fifth-per-

centile level, distributions follow the SR case. However, below that level are a greater

number of reduced distributions. Along the 50th-percentile trajectory, distributions begin

to rise after FY2030 and reach the $15 million cap in FY2042. Similarly, in the 95th-per-

centile case, distributions start to rise immediately in FY2025 and reach the cap in

FY2034.

185. Finally, under the RoP++ rule, distributions are sustained at the target level

throughout the period along the fifth-percentile line, but fall in the lower percentiles after

FY2035. The combination of the SAFER rules and an ROP revenue effort of 2.5 percent

of GDP hits the goal of attaining 95 percent on the performance indicator.


0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

16.0

COFA rules

Renewed Compact distributions in FY24 prices


0-5% ofcases

0

200

400

600

800

1000

1200

1400

COFA rules

Renewed Compact corpus in FY24 prices 50-95% of

cases

5-50% of cases

0-5% of cases

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

16.0



5-50% of cases

50-95% of cases

0-5% of cases


0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

16.0

Sustainability rule


Renewed Compact distributions in FY24 prices 0-5% of

cases

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

16.0

SAFER


5-50% of cases

50-95% of cases

0-5% ofcases

Figure 36 Comparison of distributions under the different rules

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

16.0

RoP++



0-5% of cases

85

VI. CONCLUSIONS

186. COFA Rules: It is clear the COFA rules contained in the FSM and RMI amended

Compacts produce untenable distributions. Volatility is extreme, producing many cases

of reduced and zero distributions. Accordingly, the COFA rules when viewed from the

perspective of fiscal policy are unworkable. The preferred outcome is for agreement to be

reached between the affected parties in order to eliminate the existing specification and to

adopt a more flexible approach, possibly incorporating some variant of the alternatives

proposed in this study.

187. Without change in the Compact subsidiary agreements, it would be prudent to set

a distribution policy that would allow the affected parties to have ample time to prepare

for the inevitable shortfall. This would bring about a sense of urgency and efforts to in-

crease contributions to the funds.

188. In the case of the RoP, the Compact established a sinking fund designed to pro-

vide resources for the duration of the Compact, but with no guarantee of further distribu-

tions thereafter. This study has highlighted the lack of intergenerational equity and pro-

posed the RoP move to a more fairly distributed approach and adopt a target of providing

a fixed real drawdown in FY2024 and thereafter.

189. The Moving Adjustment Rule: MAR provides a way for the corpus to adjust to

the level of the CTF, arising either from shortfalls in original funding or weak market

performance. While MAR provides improved outcomes over the existing Compact de-

sign, it does not ensure that distributions will reach the target with a desired degree of

certainty. Only additional funding will attain this objective. While the MAR adjustment

mechanism provides greater benefit to future generations, it remains biased toward the

current generation. The simulations show that the further the fund corpus is below the

primary target, the less efficient MAR is in recovery. However, adopting MAR as a sub-

sidiary component of any new specification would provide a flexible approach to helping

maintain the fund corpus, reduce volatility and support fiscal stability.

190. The Sustainability Rule: The sustainability rule drops the level of the annual dis-

tribution to a sustainable level that can be maintained with a high degree of confidence.

However, the downside is that the level of adjustment is large and implies cuts in draw-

downs of 58, 24 and 37 percent in the cases of the FSM, RMI and RoP, respectively. This

level of adjustment would lead to economic collapse in the FSM and generate fiscal insta-

bility in the RMI and RoP. However, SR does provide a known and secure level of fund-

ing that equally protects the interests of both current and future generations.

191. The SAFER Rule: Through combining the features of MAR and SR with im-

provements in distributions once the corpus has reached sustainable levels, the SAFER

rule provides the best results in simulations. The reduction in drawdowns below those

based on the long-run estimated real geometric portfolio yield results in most cases in a


buildup of the corpus until it reaches sustainable levels. This implicitly favors future gen-

erations over the present generation and thus reflects the design of the FSM and RMI

Compact subsidiary agreements. As in the case of SR, this implies significant fiscal ad-

justment when drawdowns commence.

192. The FSM Trust Fund: In FY2016, the FSM created its own trust fund. The

FSMTF was also designed on the principle of an A account (the corpus) and a B account

(a buffer account). The FSM is stricter than the COFA rules in that it protects the real

value of the corpus and not the nominal. However, it is more flexible in that it pegs draw-

downs to 5 percent of the corpus, which in the simulations undertaken equates to the real

geometric rate of return. The FSMTF displays many of the same features as the CTF in

having reduced but still significant zero or reduced distributions. While it presents a

structured approach to trust fund management, it is not appropriate for replication else-

where.

193. FAS Contributions: The only feasible alternative, to provide assured drawdowns

at current levels without fiscal adjustment, is through additional contributions to shore up

the respective CTFs. In the cases of the FSM and RMI, the current bonanza in fishing-fee

revenues provides a source of funds that can improve the anticipated shortfalls. The simu-

lations indicate that both nations can improve their respective CTF performance such that

they approach long-run sustainability.

194. However, the simulations further indicate that through establishing FAS buffer

accounts, sustainability can be achieved without modifying the existing flawed COFA

framework. The additional resources bridge the gap from any distributional shortfall but

otherwise accumulate in the FAS buffer trust fund until a threshold of sustainability is

achieved. The good results obtained may suggest that no change in the COFA arrange-

ments is required. However, the simulations are based on assumptions that both nations

commit resources at the level indicated. This, of course, is far from guaranteed. Under

such uncertainty, reform of the COFA arrangements should remain a priority; regardless

of actual FAS commitment, the CTFs should be restructured to provide a better outcome.

195. In the case of the RoP, the option of implementing the tax-reform initiative has

been used to explore the degree of adjustment necessary to maintain financial stability.

The simulations suggest that a revenue effort equivalent to 2.5 percent of GDP could es-

tablish a perpetual fund capable of sustaining itself in the face of market risks.

196. Conclusion: The analysis conducted in this study indicates that all three nations

have the power to go a long way in addressing the challenges posed by the incorporation

and reliance on trust funds in the basic fabric of fiscal operations.

87

APPENDIX 1 TECHNICAL NOTES TO THE FSM AND RMI

SIMULATIONS

1. MARKET FINANCIAL DATA AND SIMULATIONS

197. The simulations undertaken in this study are based on statistical estimates derived

from historical financial data. The data were downloaded from the Global Financial Data

online database. The following series have been utilized:

i. S&P 500 Total Return Index (with GFD extension) 35%

ii. GFD World x/USA Return Index 25%

iii. GFD Emerging Markets Return Index 5%

iv. USA 10-Year Government Bond Total Return Index 15%

v. Dow Jones Corporate Bond Return Index 10%

vi. GFD World x/USA USD TR Government Bond Index 10%

198. The data series extends from 1925 to 2017 and approximates the portfolios used

in the FSM, RMI and RoP. The weights in the portfolio of the respective series are indi-

cated on the right. It was not considered suitable to attempt to replicate the current portfo-

lios and strategies deployed as these vary over time and between build-up and drawdown

phases. In practice, the FSM has deployed a more active portfolio than the RMI, and the

RoP has followed a passive approach but with better results than the other two nations.

There is no clear evidence to indicate that a more active approach provides a better return

once management fees have been accounted for—that is, no evidence that such strategies

can outperform the market. Further, for some of the active asset classes currently de-

ployed, there is no comparable time series matching the equity and bond series used in

this study. The ADB study, which tries to mirror the investment strategies of the FSM

and RMI, deployed a series of proxies for those asset classes for which no evidence or

times series exist. The current study has assumed a management fee of 50 basis points. It

has also assumed that the portfolio is rebalanced at the end of each period.

199. The simulations undertaken are designed to incorporate the risk inherent in the

adoption of a trust fund approach to future Compact distributions relying on international

financial markets as the investment vehicle. As indicated in the country chapters, there is

considerable variation in outturn, and while the intent is to provide the most realistic pro-

jections possible, they remain indicative and designed to guide policy rather than to pro-

vide a definitive forecast. Comfort is taken from the fact that the results in this study are

broadly similar to those in the ADB and GAO studies.1

1 See US Government Accounting Office, Trust Funds for the Micronesian and the Marshall

Islands May Not Provide Sustainable Income, GAO-07-513, June 2007, Washington, DC;


200. The simulations were programmed using Oracle Crystal Ball software designed to

enable Monte Carlo simulations in an Excel-spreadsheet environment. The software is

easy to use, and, coupled with Excel, provides an excellent environment for the type of

exercise conducted here. For each time series, a log-normal distribution has been fitted to

derive estimates of the mean, standard deviation and covariances. Estimates of auto-cor-

relations were also made. With the exception of the Dow Jones bond index and GFD

World bond index, the series were not found to be significantly auto-correlated. Table A1

provides a list of the statistical estimates used.

2. SPECIFICATION OF THE ALTERNATIVE RULES

i Initial Conditions

201. In both the FSM and RMI cases, the Compact Trust Fund Subsidiary Agreement

defines the annual drawdowns to be equal to the annual grant assistance in FY2023 plus

full inflation adjustment. Grant assistance is in turn defined to include grants set forth in

section 211 in the case of the FSM and subsections (a), (d) and (e) of section 211 in the

case of the RMI. In the case of the FSM, the grants covered under section 211 are the six

sector grants and contributions to the Disaster Assistance Emergency Fund, which is

small and ignored in the simulations. The CTF Subsidiary Agreement does not indicate

that the annual drawdowns are to include the Special Supplemental Education Grant,

which is also not included in the simulations. For the FSM, the initial data point includes

the total available sector grants for FY2019. Thereafter the Congressional Budget Office

estimates of the US GDP deflator have been used to estimate future inflation and pro-

jected annual grants and target drawdowns. CTF balances for the A and C accounts have

been taken from CTF FY2017 estimates.

Asian Development Bank, Trust Funds and Fiscal Risks in the Federated States of Microne-


Aid Relationship, 2015, Manila.

Table A1 Financial data: statistical estimates of means, standard deviations, and correlations

S&P 500

Total

Return

Index

(w/GFD

extension)

GFD

World

x/USA

Return

Index

GFD

Emerging

Markets

Return

Index

USA 10-

year

Government

Bond Total

Return

Index

Dow

Jones

Corporate

Bond

Return

Index

GFD World

x/USA USD

TR

Government

Bond Index

Mean 1.0911 1.0737 1.0897 1.0282 1.0431 1.0266

Standard deviation 0.1960 0.2129 0.2369 0.0887 0.0857 0.1149

Corolation matrix

S&P 500 Total Return Index (w/GFD extension) 1.0000

GFD World x/USA Return Index 0.5431 1.0000

GFD Emerging Markets Return Index 0.3948 0.6003 1.0000

USA 10-year Government Bond Total Return Index 0.0801 0.0126 -0.1347 1.0000

Dow Jones Corporate Bond Return Index 0.3671 0.2703 0.1938 0.7771 1.0000

GFD World x/USA USD TR Government Bond Index 0.2420 0.5014 0.3235 0.4400 0.5693 1.0000

Appendix 1: Technical Notes to the FSM & RMI Simulations 89

202. In the case of the RMI, section 211 is structured slightly differently: subsection

(a) covers the five operational sector grants, subsection (d) includes the infrastructure

grant, and subsection (e) includes the Disaster Assistance Emergency Fund, which is ig-

nored. The grants related to both the Special Supplemental Education Grant and Kwaja-

lein are not included in the simulations. However, contributions by Taiwan to the A ac-

count are included, while contributions to the D account have not been included in the

base scenario as these are discretionary funds that can be withdrawn by the government

of the RMI without approval of the CTF Committee. For the RMI, the initial data point

includes the total available sector grants for FY2019. Thereafter, the Congressional

Budget Office estimates of the US GDP deflator have been used to estimate future infla-

tion and projected annual grants and target drawdowns. CTF balances for the A, C and D

accounts have been taken from CTF FY2017 estimates.

203. In the case of the RoP, the original Compact agreement of October 1994, the trust

fund subsidiary agreement, and the renewed Compact of September 2010 (which requires

ratification by the US Congress) specify the nature and conditions of the COFA Trust

Fund and drawdowns. Chapter II Table 2 provides details of the trust fund and draw-

downs. The original Compact (FY1995–FY2009) included provision for a COFA trust

fund with a contribution of $66 million in FY1995 and a further $4 million in the subse-

quent year of FY1996, thus totaling $70 million. Five years into the Compact, Palau was

entitled to draw down $5 million over the period FY2000–FY2009 and thereafter a fur-

ther $15 million during the remainder of the 50-year Compact period through FY2044.

Under the renewed Compact, for a further 15 years, the US agreed to contribute $3 mil-

lion per annum to the fund while offsetting this by permitting a rising level of withdraw-

als from the current $5 million to $15 million in FY2024. After FY2024, permitted draw-

downs remain at the nominal $15 million agreed under the original Compact.

ii Definitions

Actual CTF value in period t CTF(t)

Primary-target fund estimate PT(t)

Target distribution in period t as per COFA TarD(t)

Distribution in period t D(t)

Long-run historical real geometric yield on portfolio Y

US GDP deflator in period t (percent of prior year) Px(t)

For MAR (moving average rule):

CTF moving average CTF_MA(t) 3-year MA1

Ratio of CTF(t) to PT(t) RC(t)

Ratio of D(t) to TarD(t) RD(t)

Annual decrement; years > FY2024 dec sim value 0.05

Maximum annual decrement in FY2024 dec24 sim value 0.15

1 In the initial years between FY2024 and FY2026, a moving average is taken over the period

FY24-t.


Annual increment inc sim value 0.02

For SR (sustainability rule):

The sustainability adjustor sus sim value 0.67

The SR primary target srPT(t)

Distribution target in period t under SR TarDsr(t)

For the SAFER rule:

Ratio of CTF(t) to srPT(t) RCsr(t)

Ratio of D(t) to TarDsr(t) RDsr(t)

Venting increment Vent sim value 0.05

Venting threshold VentT sim value 1.0

iii MAR (Moving Adjustment Rule) Equations

In the MAR simulations, a downward adjustment, or decrement, of the previous year’s

distribution is made if a five-year moving average of the CTF value falls below the pri-

mary target. Downward adjustment continues until the reduction in distribution exceeds

the CTF shortfall (the ratio of the actual moving-average CTF value to the primary tar-

get). At this point, an upward adjustment, or increment, is made. Adjustment is thus

asymmetric: on the downside, adjustment is more rapid, and on the upswing, adjustment

is slower in order to allow the CTF to return more rapidly to the primary target. On the

upside, when the CTF value exceeds the primary target, there is no allowance for venting.

These adjustment mechanisms are described mathematically as follows:

The target distribution is defined as follows:

TarD(FY24) = As per COFA (1)

TarD(t) = TarD(t-1) * Px(t-1) (2)

The primary target is defined as follows:

PT(t) = TarD(t) / Y (3)

Indicator of fund performance RC(t) is defined as follows:

RC(t) = CTF_MA(t) / PT(t) (4)

Drawdown as a proportion of the target distribution is defined as follows:

RD(t) = D(t) / TarD(t) (5)

Drawdown in FY2024 is given by the following:

When RC(t) < 1 when (1-dec24) < RC(t) < 1, drawdown is as follows:

D(t) = TarD(t) * RC(t)

When RC(t) < (1-dec24),

D(t) = TarD(t) * (1-dec24). (6)

Appendix 1: Technical Notes to the FSM & RMI Simulations 91

When RC(t) >= 1,

D(t) = max(CTF(t-1), TarD(t)). (7)

Drawdown in years beyond FY2024 is given by the following:

When RC(t) < RD(t-1),

D(t) = min(CTF(t-1), TarD(t) * RD(t-1) * (1-dec)). (8)

When RC(t) = RD(t-1),

D(t) = min(CTF(t-1), TarD(t) * RD(t-1)) (9)

When RC(t) > RD(t-1) and RD(t-1) * (1+inc) < 1,

D(t) = min(CTF(t-1), TarD(t) * RD(t-1) * (1+inc)). (10)

When RC(t) > RD(t-1) and RD(t-1) * (1+inc) >= 1,

D(t) = min(CTF(t-1), TarD(t)). (11)

iv SR (Sustinability Rule) Equations

In the case of the sustainability adjustment, a new drawdown is defined in the initial year

to support a sustainable distribution based on a certain proportion below the long-run ge-

ometric portfolio yield Y and thereafter as follows:

Drawdown in FY2024:

srPT(FY23) = CTF(FY23) * 1/(1+sus) (12)

TarDsr(FY24) = srPT(FY23) * Y (13)

D(FY24) = TarDsr(FY24) (14)

Drawdown after FY2024:

TarDsr(t) = TarDsr(t-1) * (1 + Px(t-1)) (15)

D(t) = min(CTF(t-1), TarDsr(t)) (16)

v The SAFER (Sustainability Adjustment for Enhanced Reliability Rule) Equations

The SAFER rule is a combination of MAR and SR, with a modification for venting. Un-

der SAFER, an adjustment is made in the initial year as specified under SR. From this

point onward, the MAR equations kick in. In the initial year, there will be no adjustment

as, by definition, the CTF value is above PT. However, from this point on, MAR adjust-

ments can take place if a sequence of poor market returns is experienced. Under the

SAFER rule, distributions are allowed to grow above target if a venting threshold is ex-

ceeded and the new distribution does not exceed the original COFA rule.

The following formulas apply:

srPT(FY23) = CTF(FY23) * 1/(1+sus) (17)

TarDsr(FY24) = srPT(FY23) * Y (18)


D(FY24) = TarDsr(FY24) (19)

srPT(t) = srPT(t-1) * Px(t-1) (20)

TarDsr(t) = srPT(t-1) * Y (21)

RCsr(t) = CTF_MA(t) / srPT(t) (22)

RDsr(t) = Dsr(t) / TarDsr(t) (23)

Drawdown in FY2024:

srPT(FY23) = CTF(FY23) * 1/(1+sus) (24)

D(FY24) = srPT(FY23) * Y (25)

Drawdown after FY2024 when CTF(t) > srPT(t) and CTF(t) < srPT(t) * (1+VentT):

TarDsr(t) = TarDsr(t-1) * (1 + Px(t-1)) (26)

D(t) = TarDsr(t) (27)

The MAR adjustment is activated after FY2024 when CTF(t) < srPT(t) and is given by

the following:

When RCsr(t) < RDsr(t-1),

D(t) = min(CTF(t-1), TarDsr(t) * RDsr(t-1) * (1-dec)). (28)

When RCsr(t) = RDsr(t-1),

D(t) = min(CTF(t-1), TarDsr(t) * RDsr(t-1)). (29)

When RCsr(t) > RDsr(t-1) and provided RDsr(t-1) * (1+inc) < 1,

D(t) = min(CTF(t-1), TarDsr(t) * RDsr(t-1) * (1+inc)). (30)

When RCsr(t) > RDsr(t-1) and RDsr(t-1) * (1+inc) >= 1,

D(t) = min(CTF(t-1), TarDsr(t)). (31)

The venting threshold is activated after FY2024 when CTF(t) > srPT(t) * (1+VentT):

D(t) = min(TarD(t), D(t-1) * (1 + Vent)) (32)

compact cofa cpi ctf fsm gdp jemfac rmi rop · iv e. comparison of the different rules 29 f. cofa...

Documents