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
Figure 7 Distributions by number of cases falling in selected ranges under
MAR rules 24
Figure 8 selected CTF trajectories and drawdowns under the MAR Rules 25
Figure 9 Distributions by number of cases falling in selected ranges under
SR rules 27
Figure 10 Distributions by number of cases falling in selected ranges under
SAFER rules 29
Figure 11 Comparison of distributions under the different rules 31
Figure 12 Distributions by number of cases falling in selected ranges under
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
Figure 17 Distributions by number of cases falling in selected ranges under
COFA rules 48
Figure 18 Randomly selected CTF trajectories and drawdowns 50
Figure 19 Distributions by number of cases falling in selected ranges under
MAR rules 52
Figure 20 Randomly selected CTF trajectories and drawdowns under MAR 53
Figure 21 Distributions by number of cases falling in selected ranges under
SR rules 56
Figure 22 Distributions by number of cases falling in selected ranges under
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
Figure 30 Distributions by number of cases falling in selected ranges under
the renewed Compact 74
Figure 31 Distributions by number of cases falling in selected ranges under
the Moving Average Rule 76
Figure 32 Distributions by number of cases falling in selected ranges under
the Sustainability Rule (SR) 78
Figure 33 Distributions by number of cases falling in selected ranges under
the SAFER Rule 79
Figure 34 Probability Distribution of the Compact Trust Fund with RoP
contributions 80
Figure 35 Distributions by number of cases falling in selected ranges under
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.
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.
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
4 Compact Trust Funds in the Freely Associated States
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
Trust Fund Dynamics 5
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).
6 Compact Trust Funds in the Freely Associated States
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
Trust Fund Dynamics 7
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.
8 Compact Trust Funds in the Freely Associated States
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
Trust Fund Dynamics 9
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-
sia and the Marshall Islands: Analysis of Trust Fund Rules and Sustainability in an Evolving
Aid Relationship, 2015, Manila. 3 See http://www.globalfinancialdata.com, Global Financial Data, San Juan Capistrano, CA.
10 Compact Trust Funds in the Freely Associated States
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-
Trust Fund Dynamics 11
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%
12 Compact Trust Funds in the Freely Associated States
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.
Trust Fund Dynamics 13
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)
16 Compact Trust Funds in the Freely Associated States
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
The FSM Compact Trust Fund 17
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
18 Compact Trust Funds in the Freely Associated States
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
The FSM Compact Trust Fund 19
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
20 Compact Trust Funds in the Freely Associated States
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
The FSM Compact Trust Fund 21
$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
"A" account after distributn "C" account after distributnTarget Distribution Distribution
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
"A" account after distributn "C" account after distributnTarget Distribution Distribution
Sim 9
Average rate of return 8.8% Geometric rate 8.5%
Average rate of return 9.3% Geometric rate 8.5%
Average rate of return 6.5% Geometric rate 5.8%
Sim 5
22 Compact Trust Funds in the Freely Associated States
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
"A" account after distributn "C" account after distributnTarget Distribution Distribution
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
"A" account after distributn "C" account after distributnTarget Distribution Distribution
Sim 16
Average rate of return 7.9% Geometric rate 7.4%
The FSM Compact Trust Fund 23
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.
1. TRUST FUND PERFORMANCE
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,
24 Compact Trust Funds in the Freely Associated States
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
FY25 FY30 FY35 FY40 FY45 FY50
The FSM Compact Trust Fund 25
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
$3.0bCTF Value Target Distribution Distribution
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
26 Compact Trust Funds in the Freely Associated States
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.
1. THE SUSTAINABILITY RULE (SR)
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.
The FSM Compact Trust Fund 27
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
FY25 FY30 FY35 FY40 FY45 FY50
28 Compact Trust Funds in the Freely Associated States
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.
2. THE SUSTAINABILITY ADJUSTMENT FOR ENHANCED RELIABILITY RULE
(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
The FSM Compact Trust Fund 29
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
30 Compact Trust Funds in the Freely Associated States
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
The FSM Compact Trust Fund 31
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
Amended Compact distributions in FY23 prices
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
Amended Compact distributions in FY23 prices
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
Amended Compact distributions in FY23 prices
5-50% ofcases
50-95%of cases
32 Compact Trust Funds in the Freely Associated States
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
Compact Trust Fund Corpus results
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%
Distribution results
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
The FSM Compact Trust Fund 33
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
34 Compact Trust Funds in the Freely Associated States
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
Compact Trust Fund Corpus results
Probability of real CTF in FY50 > the FY23 value 21.7% 65.2% 80.0%
Probability of real CTF value > the Primary Target in FY50 13.9% 41.1% 62.2%
Distribution results
Average distribution through FY24-FY50 % target 77.1% 77.0% 56.5%
Proabability of attaining target distribution in FY50 38.6% 35.7% 40.8%
Volatitity results
Probability of a zero distribution between FY24 to FY50 73.2% 29.8% 0.0%
Distribution % prior year counted for reduction years only 28.4% 15.8% 4.8%
Overall performance rating 41.6% 62.2% 72.5%
COFA, SAFER and FSM rules at median values
The FSM Compact Trust Fund 35
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
36 Compact Trust Funds in the Freely Associated States
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
The FSM Compact Trust Fund 37
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
Compact Trust Fund Corpus results
Probability of real CTF in FY50 > the FY23 value 87.6% 93.9% 83.4% 74.7%
Probability of real CTF value > the Primary Target in FY50 78.1% 87.0% 77.6% 70.2%
Distribution results
Average distribution through FY24-FY50 % target 92.8% 92.2% 95.4% 99.3%
Proabability of attaining target distribution in FY50 85.5% 85.3% 79.7% 94.6%
Volatitity results
Probability of a zero distribution between FY24 to FY50 41.3% 13.7% 0.0% 0.0%
Distribution % prior year counted for reduction years only 10.7% 9.8% 0.7% 0.6%
Overall performance rating 82.0% 89.1% 89.2% 89.7%
Additional FSM Contributions
38 Compact Trust Funds in the Freely Associated States
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
The FSM Compact Trust Fund 39
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.
40 Compact Trust Funds in the Freely Associated States
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
100.0 Amended Compact distributions in FY23 prices
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
100.0 Amended Compact distributions in FY23 prices
0-5% of cases
5-50% of cases
SAFER++
50-95% of cases
The FSM Compact Trust Fund 41
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
100.0 Amended Compact distributions in FY23 prices
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).
44 Compact Trust Funds in the Freely Associated States
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.
The RMI Compact Trust Fund 45
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
46 Compact Trust Funds in the Freely Associated States
B. Simulating the CTF under the COFA Rules
1. TRUST FUND PERFORMANCE
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
The RMI Compact Trust Fund 47
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
Compact Trust Fund Corpus results
Probability of real CTF in FY50 > the FY23 value 72.8% 73.8% 83.0% 82.4%
Probability of real CTF value > the Primary Target in FY50 77.7% 78.7% 87.8% 87.5%
Distribution results
Average distribution through FY24-FY50 % target 94.1% 94.5% 79.8% 87.5%
Proabability of attaining target distribution in FY50 83.2% 74.3% 19.1% 71.4%
Volatitity results
Probability of a zero distribution between FY23 to FY50 34.7% 0.1% 0.3% 0.0%
Distribution % prior year counted for reduction years only 8.8% 0.6% 0.1% 0.5%
Overall performance rating 80.7% 86.8% 78.2% 88.0%
Rule Sets
48 Compact Trust Funds in the Freely Associated States
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
The RMI Compact Trust Fund 49
Average rate of return 8.8% Geometric rate 8.5%
Average rate of return 9.3% Geometric rate 8.5%
Average rate of return 6.5% Geometric rate 5.8%
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
"A" account after distributn "C" account after distributnTarget Distribution Distribution
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
"A" account after distributn "C" account after distributnTarget Distribution Distribution
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
"A" account after distributn "C" account after distributnTarget Distribution Distribution
Sim 9
Average rate of return 8.8% Geometric rate 8.5%
Average rate of return 6.5% Geometric rate 5.8%
Average rate of return 9.3% Geometric rate 8.5%
50 Compact Trust Funds in the Freely Associated States
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 3.3% Geometric rate 2.8%
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
"A" account after distributn "C" account after distributnTarget Distribution Distribution
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
"A" account after distributn "C" account after distributnTarget Distribution Distribution
Sim 14
Average rate of return 6.8% Geometric rate 6.0%
Average rate of return 7.9% Geometric rate 7.4%
The RMI Compact Trust Fund 51
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
adjustment continues until the reduction in distribution exceeds the CTF shortfall (the ra-
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.
52 Compact Trust Funds in the Freely Associated States
1. TRUST FUND PERFORMANCE
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
FY25 FY30 FY35 FY40 FY45 FY50
The RMI Compact Trust Fund 53
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
$3.0bCTF Value Target Distribution Distribution
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
$3.0bCTF Value Target Distribution Distribution
Sim 24
Average rate of return 5.9% Geometric rate 5.1%
Average rate of return 8.0% Geometric rate 7.0%
54 Compact Trust Funds in the Freely Associated States
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.
D. The Sustainability Adjustment for Enhanced Reliability (SAFER) Rule
116. 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 firstly simulate SR on its own and then augment it with
MAR and arrive at SAFER.
1. THE SUSTAINABILITY RULE (SR)
117. 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.
The RMI Compact Trust Fund 55
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.
56 Compact Trust Funds in the Freely Associated States
2. THE SUSTAINABILITY ADJUSTMENT FOR ENHANCED RELIABILITY RULE
(SAFER)
122. 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.
123. Referring back to Table 8, 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 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
FY25 FY30 FY35 FY40 FY45 FY50
The RMI Compact Trust Fund 57
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
FY25 FY30 FY35 FY40 FY45 FY50
58 Compact Trust Funds in the Freely Associated States
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.
The RMI Compact Trust Fund 59
$0
$5
$10
$15
$20
$25
$30
$35
Moving adjustment rule
Amended Compact distributions in FY23 prices
5-50% of cases
$0
$5
$10
$15
$20
$25
$30
$35
Sustainability rule
5-95% of cases lie along this line
Amended Compact distributions in FY23 prices
$0
$5
$10
$15
$20
$25
$30
$35
COFA rules
5-25% of cases
Amended Compact distributions in FY23 prices
60 Compact Trust Funds in the Freely Associated States
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
Amended Compact distributions in FY23 prices
5-50% of cases
50-95% of cases
The RMI Compact Trust Fund 61
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.
134. Figure 24 indicates the probability distribution of the likely size of the CTF in
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
Compact Trust Fund Corpus results
Probability of real CTF in FY50 > the FY23 value 72.8% 84.3% 82.4%
Probability of real CTF value > the Primary Target in FY50 77.7% 89.1% 87.5%
Distribution results
Average distribution through FY24-FY50 % target 94.1% 85.2% 87.5%
Proabability of attaining target distribution in FY50 83.2% 66.6% 71.4%
Volatitity results
Probability of a zero distribution between FY23 to FY50 34.7% 22.7% 0.0%
Distribution % prior year counted for reduction years only 8.8% 6.2% 0.5%
Overall performance rating 80.7% 82.7% 88.0%
COFA and SAFER
62 Compact Trust Funds in the Freely Associated States
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
The RMI Compact Trust Fund 63
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
Compact Trust Fund Corpus results
Probability of real CTF in FY50 > the FY23 value 86.8% 85.8% 82.3%
Probability of real CTF value > the Primary Target in FY50 91.0% 91.1% 87.3%
Distribution results
Average distribution through FY24-FY50 % target 95.7% 97.4% 99.5%
Proabability of attaining target distribution in FY50 88.9% 88.2% 97.8%
Volatitity results
Probability of a zero distribution between FY23 to FY50 30.4% 0.0% 0.0%
Distribution % prior year counted for reduction years only 6.8% 0.2% 0.6%
Overall performance rating 87.5% 93.7% 94.4%
Additional RMI Contributions
64 Compact Trust Funds in the Freely Associated States
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
35.0 Amended Compact distributions in FY23 prices
5-10% of cases
0-5% of cases
10-15% of cases
COFA++
The RMI Compact Trust Fund 65
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
35.0 Amended Compact distributions in FY23 prices
0-5% of cases
5-100% of cases meet target
RMI buffer
66 Compact Trust Funds in the Freely Associated States
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
68 Compact Trust Funds in the Freely Associated States
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
70 Compact Trust Funds in the Freely Associated States
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
The RoP Compact Trust Fund 71
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.
B. Simulating the CTF under the COFA Rules
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
72 Compact Trust Funds in the Freely Associated States
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
The RoP Compact Trust Fund 73
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%
Distribution results
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
74 Compact Trust Funds in the Freely Associated States
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
adjustment continues until the reduction in distribution exceeds the CTF shortfall (the ra-
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
The RoP Compact Trust Fund 75
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++
Compact Trust Fund Corpus results
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%
Distribution results
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
76 Compact Trust Funds in the Freely Associated States
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.
D. The Sustainability Adjustment for Enhanced Reliability (SAFER) Rule
166. 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.
1 See appendix 1 for full specification of the sustainability and SAFER rules for the RoP.
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
The RoP Compact Trust Fund 77
1. THE SUSTAINABILITY RULE (SR)
167. 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 multiplication of the estimated real
geometric 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 FY2025 has been determined, an annual adjustment for inflation is permitted
but without further modification.
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.
2. THE SUSTAINABILITY ADJUSTMENT FOR ENHANCED RELIABILITY RULE
(SAFER)
171. 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.
78 Compact Trust Funds in the Freely Associated States
172. Referring back to Table 12, 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 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
The RoP Compact Trust Fund 79
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
80 Compact Trust Funds in the Freely Associated States
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.
177. Figure 34 indicates the probability distribution of the likely size of the CTF in
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
The RoP Compact Trust Fund 81
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
82 Compact Trust Funds in the Freely Associated States
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.
The RoP Compact Trust Fund 83
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
5-95% of cases lie along this line
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
Moving adjustment rule
Renewed Compact distributions in FY24 prices
5-50% of cases
50-95% of cases
0-5% of cases
84 Compact Trust Funds in the Freely Associated States
0.0
2.0
4.0
6.0
8.0
10.0
12.0
14.0
16.0
Sustainability rule
5-95% of cases lie along this line
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
Renewed Compact distributions in FY24 prices
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++
Renewed Compact distributions in FY24 prices
5-95% of cases lie along this line
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
86 Compact Trust Funds in the Freely Associated States
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;
88 Compact Trust Funds in the Freely Associated States
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-
sia and the Marshall Islands: Analysis of Trust Fund Rules and Sustainability in an Evolving
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.
90 Compact Trust Funds in the Freely Associated States
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)
92 Compact Trust Funds in the Freely Associated States
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)