Federated States of Micronesia: Selected Issues and Statistical Appendix

This Selected Issues paper examines the reasons for the poor initial performance of the Compact Trust Fund (CTF) of Micronesia and the issues related to the governance framework. The design and recent implementation of the CTF raise concerns that Micronesia will still face a difficult transition after U.S. aid ends in FY2023. The paper provides forecasts for the fund over the medium term. It also examines the business environment in Micronesia and identifies possible areas for improvement.

Abstract

This Selected Issues paper examines the reasons for the poor initial performance of the Compact Trust Fund (CTF) of Micronesia and the issues related to the governance framework. The design and recent implementation of the CTF raise concerns that Micronesia will still face a difficult transition after U.S. aid ends in FY2023. The paper provides forecasts for the fund over the medium term. It also examines the business environment in Micronesia and identifies possible areas for improvement.

I. Strengthening Micronesia’s Compact Trust Fund1

A. Introduction

1. The amended Compact of Free Association (FY2004–23) created a trust fund to help replace U.S. grants to the Federated States of Micronesia (FSM) after the Compact ends. During the Compact negotiations, there was a recognition this would be the last to provide substantial financial assistance. At the same time, both sides also realized that an abrupt end to aid would be disruptive. Thus, there was a need to create a mechanism to provide a more permanent source of assistance to help maintain living standards, which was also independent of a compact treaty with the United States.

2. The negotiators decided to establish a trust fund that would grow over the life of the Compact through a series of regular contributions. The agreement built in a gradual reduction of grant aid to the budget, which was meant to encourage greater financial self-reliance. At the same time, the saving from these reductions would be used to build up a Compact Trust Fund (CTF) that could be drawn upon after 2023. The design of the fund drew partially on the experience of other trust funds in the Pacific (Box 1).

3. However, the design and recent implementation of the CTF raise concerns that Micronesia will still face a difficult transition after U.S. aid ends in FY2023. The slow start and low initial returns of the fund suggest that the governance framework may need to be reexamined to ensure that the CTF achieves its overall objectives. This chapter examines the reasons for the poor initial performance and issues related to the governance framework of the fund. It also provides forecasts for the fund over the medium-term and concludes with some possible policy prescriptions to help bring fund’s operation closer to the best practices used by other government-run trusts.

B. Operational Framework of the Trust Fund

4. The CTF was endowed in 2004 and will be funded over the next 20 years with a series of steadily rising payments. In 2004, the Micronesian government capitalized the fund with a $30 million endowment. Since then, the United States has contributed around $16 million. U.S. payments are scheduled to rise by around $800,000 per year (partially inflation-indexed) through 2023.2 The U.S. contribution schedule is, in effect, heavily back-loaded. As a result, by the end of the Compact, the principal is estimated to account for just over two-thirds of the overall balance of the fund.

uA01fig01

CTF: Contributions and Balances

U.S. and FSM contributions (by fiscal year, left axis) and Sum of past contributions and net earnings (right axis) (in millions of constant 2007 U.S. dollars)

Citation: IMF Staff Country Reports 2007, 105; 10.5089/9781451813807.002.A001

Trust Funds in the Pacific

At least seven Pacific Island countries established trust funds to manage large, anticipated inflows, either from natural resources or with the support of international donors.

Kiribati Revenue Equalization Reserve Fund (1956). The fund was capitalized from phosphate mining revenue. It is entirely locally run, with the trustees consisting of the Minister of Finance (chair), the Secretary to the Cabinet, the Chief Accountant, and two others. In 1996, the fund adopted a target of maintaining a constant real per capita value. Prudent fiscal management by successive governments and sound investment policy enabled the trust’s value to increase for many years in real terms, although it has come under pressure from high government draw-downs to finance budget deficits since 2003.

Tuvalu Trust Fund (1987). The fund was initially capitalized with $A27 million, primarily by donors (United Kingdom, New Zealand, Australia Japan, and Korea), but also with a contribution from Tuvalu. The fund was created to provide budget support and to promote financial independence. The board of directors are from Tuvalu (chair), Australia, New Zealand and the United Kingdom. Sound investment decisions and limited withdrawals have helped lift the value of the fund considerably. To prevent large fluctuations in investment income from disrupting the budget, the fund established a dual account system, where one account served as a “buffer,” that accumulated reserves during periods of high returns and could be drawn down during periods of low returns. (The CTF uses a similar system, drawing on the Tuvalu experience.)

Compact Trust Fund—Palau (1994). The United States provided the initial capitalization of $70 million (1995-97), with an aim to replace the government’s reliance on U.S. grants after the Compact expires in 2044. Palauans comprise the seven-member board. The government could withdraw limited amounts starting in 1999, but chose to reinvest most of the earnings, lifting the fund to $150 million by 2004. The long-run outlook is uncertain, because the fund was based on a highly optimistic assumption of annual returns of 12½ percent during the first 15 years.

Compact Trust Fund—Republic of Marshall Islands and Federated States of Micronesia (2004). The operation of these funds are nearly identical, although the U.S. contributions are higher to Micronesia’s fund (reflecting the country’s larger size and higher Compact grant funding).

Nauru Phosphate Royalties Trust (1968). The Trust was capitalized using dividends and taxes from phosphate mining and was intended to provide income after reserves ran out. High initial revenues swelled the balance to A$1½ billion in 1990. As reserves ran out, mining contributions to both the budget and the trust fund fell, and the government borrowed heavily, using the fund as collateral. These draw-downs, along with poor investment returns and corruption, caused the fund to be virtually exhausted.

Tonga Trust Fund (1988). The fund was capitalized from the sale of passports to foreigners (primarily to residents of Hong Kong SAR) and the lease of Tongan satellite space. The Board of Trustees comprised of the Prime Minister (chair), Minister of Finance, plus one. The funds were invested in bank deposits until 1999, and the balance rose to $26 million. In 1999, the King appointed a U.S. citizen as the investment manager, who lost the entire balance by 2002.

Marshall Islands Nuclear Claims Fund (1986). The United States provided $150 million to compensate residents who suffered from U.S. nuclear testing between 1946-58. While the fund was intended to last in perpetuity, the fund fell by 15 percent in value during the 1987 stock market and never recovered, in part because of large payments to the victims of testing. The current fund balance is only around $5 million.

5. The agreement governing the trust fund places oversight in the hands of a Joint Trust Fund Committee (JTFC). The committee is comprised of three members from the United States and two from Micronesia.3 The initial responsibilities included hiring service providers: (i) a trustee4 to collect funds, manage the disbursement, and act as the day-to-day overseer; (ii) investment managers to recommend a portfolio; and (iii) money managers to handle the funds. The JTFC was also to establish, and regularly revise, an investment policy.5

6. There are also specific financial controls, aimed at safeguarding the fund. Chief among these is a prohibition of borrowing against future trust fund income and a separation of U.S. and Micronesian contributions into different accounts. The agreement requires an annual report and audit within six months after the end of the fiscal year. These reports must clearly “segregate and identify gross income, management fees, and net income.”6

7. Indeed, these financial controls even outlive the Compact and impose conditions on the use of funds during the draw-down phase. Starting in FY2024, and running until FY2043, the JTFC would oversee the allocation of income from the fund. Disbursements are to be targeted to the same areas (health, education, environment, infrastructure, capacity building, and private sector development)—and to use the same fiscal expenditure controls—as under the existing Compact. If Micronesia fails to meet the requirements specified in the agreement, the United States has the right to withdraw the present market value of all its contributions and net earnings.

8. The agreement preserves the nominal value of the CTF by limiting withdrawals. The agreement creates three accounts: (i) the “A” account that is the capital of the fund; (ii) the “B” account that holds all of the investment income from the “A” account starting in FY2023; and (iii) a “C” account that acts as a “buffer” (from FY2004-22, investment income above six percent is deposited into the “C” account). Starting in FY2024, the JTFC can draw down on the CTF, but only through the “B” account (and if any funds are available, from the “” account).

C. Initial Practices of the Trust Fund Management

9. The JTFC experienced a slow start, resulting in low returns. The Micronesian and U.S. governments did not fully staff the JTFC until July 2005. The board members did not approve an investment advisor until September 2005—and a trustee until May 2006. As a result of the delay, the CTF was invested in bank deposits and money market funds, earning around 2½ percent (Micronesia OPNA, 2006).

10. The slow start resulted in missing important deadlines for producing financial statements. The first annual report was not produced until March 2006, more than one year late and was not audited. By October 2006, an auditor had not been selected. The annual report (JTFC, 2006) did not provide a full report on the accounts, including balances, gross returns, and management fees. Also, the JTFC has not conducted a long-term analysis of the fund’s operation whether current policies would meet the goals spelt out in the agreement.

11. Many of the difficulties in implementation appear to be the result of the JTFC attempting to fulfill many roles. The Micronesian and U.S. governments decided to appoint the same people to the JTFC as to JEMCO—the joint committee responsible for overseeing and approving Compact grants. However, committee members have spent a significant amount of time to resolve problems that arose in implementing the new Compact. (GAO, 2006b, has a summary of the grant management issues experienced over the past three years).

12. This diffuse responsibility has meant that the committee has not met regularly to focus on issues surrounding the trust fund. Meetings are only required annually and have been tacked on at the end of the U.S.-Micronesia Compact meetings to consider grant requests by the national and state governments. This has not afforded the committee sufficient time to focus on the long-range, complex, and strategic issues involved in running a trust fund.

13. The JTFC also does not appear to have the requisite experience to effectively manage a trust fund. Micronesian members are currently the head of the Office of Compact Management and the Secretary for Foreign Affairs. Although well-qualified in their fields of expertise, neither specialize in financial affairs, nor do they have staff whom could be drawn upon to analyze the performance of the fund, monitor the investment advisors, provide independent analysis of advisors’ recommendations, and produce long-range forecasts.

14. However, such experience is available in Micronesia, and some governmental units have managed financial assets well. The Micronesian Department of Finance and Administration has managed the financial investments of the national government and states at a relatively low cost (around 80 basis points), yielding comparable returns as larger investors. The state of Yap has done a good job managing its state-owned trust fund (around $30 million), which provides a significant share of the state government’s revenues. The Micronesian Social Security Administration (SSA) invests workers’ contributions in a broad mix of assets, guided by U.S.-based investment advisers. Their annual accounts are audited and made public on the web site. They provide a clear description of costs, gross and net returns, and assets, along with long-range actuarial forecasts (FSM SSA, 2006).

D. Medium-term Outlook for the Trust Fund

15. This section provides a medium-term analysis for the balance of the trust fund and its ability to meet the funding needs of the Micronesian government. This analysis is motivated by findings that CTF could fail to provide enough income in FY2024 to replace expiring Compact grants (GAO, 2003).

16. The analysis considers outcomes of the fund under three scenarios regarding the investment strategy and management:

  • Conservative strategy. The gross nominal investment returns are assumed to be seven percent, with management and custodial fees of 100 basis points. This net return (six percent) matches the assumed rate of return when the U.S. Department of State designed the trust fund (GAO, 2006a). The designers of the fund assumed a return that was only marginally higher than the long-term forecasted returns on U.S. Treasury bonds, to reflect a conservative investment strategy.

  • Authorities 2006 strategy. Partly because of the slow start to investing the CTF funds and need to raise returns, the authorities chose a more aggressive investment strategy. In August 2006, the trust fund was invested 100 percent in equities (57 percent in a fund tracking the Russell 3000, and 43 percent in a fund tracking the MSCI EAFE index).7 Over time, bonds will be gradually added. This simulation assumes that the equity share is reduced by three percentage points annually (1½ percent for each equity fund), until equities account for only about one-third of holdings (24 percent in U.S. equities; 10 percent international). The reduction in the share of equity assets is used to purchase short (six month), medium, (five year) and long-term (ten year) U.S. Treasury bonds. The scenario assumes that the rebalancing process keeps the share of each maturity of bonds in its portfolio equal.

    The investment returns from this strategy are calculated using historical yields on these funds. On average, net real investment returns are around 4¼ percent (about 75 basis points higher than the real return in the Conservative investment strategy). This return is not constant, but simulated by randomly drawing yields from the historical experience of the joint, total returns of the five indices (U.S. Russell 3000, MSCI EAFE, and total returns of bond indices for the six-month, five-year, and ten-year Treasuries). Management fees are assumed to be 100 basis points.

  • Authorities 2006 strategy, plus another 100 basis points higher management fees. This scenario assumes the same investment strategy as is currently being followed. However, management and custodial fees are 200 basis points, claiming 2 percent of assets each year. Under this assumption, the total returns to the fund fall sharply, reflecting the large effect that fees have on the eventual outcome of the fund.

17. To maintain the focus on the effects of differing asset management strategies, the three scenarios use common economic assumptions. CPI inflation is 2½ percent annually, equal to long-term U.S. inflation estimates, since the U.S. dollar is the official currency. Medium-term real GDP growth is ¾ percent, assuming labor productivity grows at ½ percent per year, and the labor force expands only ¼ percent per year (equal to long-run estimates of Micronesian population growth). This growth rate is based on unchanged economic policies. If structural reforms and fiscal adjustment are implemented, then GDP growth could reach 2¾ percent annually. The U.S. GDP price deflator (used to calculate annual U.S. support) is taken from official U.S. sources.8 The scenarios, below, do not consider different economic assumptions, because such changes would alter the relative importance of the trust fund to the Micronesian economy and obscure the direct effects of investment strategies on the fund’s value.

18. Under the Conservative investment strategy, the CTF will fall well short of what is needed to replace expiring Compact grants. Compact grants would be 19½ percent of GDP in FY2023, while the income from the fund would be only 12¼ percent of GDP in the following year. Going forward, investment income would continue to be well below the FY2023 Compact grant levels.9 Furthermore, the agreement only attempts to preserve the fund’s nominal value by preventing the government from making withdrawals from the “A” Account. Thus, the Micronesian government could withdraw all investment income each year, leaving no reserves to ensure that the fund grows to keep pace with inflation. Over time, the funds’ real per capita value would also fall, implying dwindling resources for the government. (The present value of the fund required to maintain constant spending is near $1 billion.)

uA01fig02

Impact of Investment Strategies

Balance in the Compact Trust Fund (millions of constant 2007 U.S. dollars)

Citation: IMF Staff Country Reports 2007, 105; 10.5089/9781451813807.002.A001

19. A loss of income of this magnitude would imply a sustained drag on growth. The forecast would foresee a loss of revenue of around 7 percent of GDP in FY2024. This would force immediate and painful cuts in government spending. Their effect would be magnified, because government income would be permanently lower—and falling at a rate equal to inflation plus population growth.

20. The Authorities 2006 investment strategy would have only a marginal impact on the fund’s balance in FY2023. Under this scenario, the trust fund is estimated to be only 4¾ percent larger than if the Conservative investment strategy were followed. This small improvement reflects, in part, the decision to gradually shift to a more conservative asset allocation. However, even more risky strategies would not improve the outcome significantly. If the portfolio were not diversified (keeping 100 percent in equities, with a 53/47 split between U.S and international stocks), the balance of the fund would be 12 percent higher than the Authorities 2006 investment strategy—again, well below what is required. These riskier strategies have a small impact because contributions are back-loaded; in the final four years, they account for nearly one-quarter of the FY2023 principal.

21. Analysis also suggests that a significant risk to the fund are management fees. 10 With a 100 basis points increase in management fees, the trust fund balance would be nearly 10 percent ($70 million 2007 U.S. dollars) lower. This suggests that every effort should be made to keep costs under control.

E. Improving the Operation and Oversight of the Fund

22. Given the importance of the CTF to the future of Micronesia, it is essential that the board members overseeing the fund adopt best practices (Box 2). Regardless of the rate of growth of the Micronesian economy, it is very likely that the trust fund will provide a large share of the government’s revenue. It is essential that the investment managers act promptly to take the greatest advantage of the long time horizon. At the same time, the JTFC must exercise strong oversight in monitoring the service profits, to help hold down costs from fees—one of the biggest risks to the fund.

23. The CTF agreement has strong controls in place, particularly over the monitoring and eventual disbursement of funds. Micronesia must implement the fiscal controls in order to receive disbursements from the CTF. Similarly, the JTFC must produce audited annual reports.

Lessons from Pacific Island Trust Funds

A review of Pacific island trust funds distills a set of concrete recommendations and best practices reflecting their experiences (both success and failures).

Good governance:

  • Independent operation. The trust fund committee must be able to withstand political pressure. In Kiribati, the Minister of Finance is the chair (in Palau, the President). In Tuvalu, while there is significant donor involvement, there is also considerable local involvement in decision-making.

  • Local ownership and understanding. The fund should have locally-determined goals. Ideally, these are contained in legislation, which affords public debate. The public should also be updated regularly if the fund is on track to achieve its goals.

  • Open and transparent operation. The trust fund should be subject to annual audits. Annual reports are essential, but the public should also have quarterly reports on the balances, income, and costs of the fund, along with a simple update of long-range forecasts from the last annual report.

Strong fiduciary practices:

  • Robust fiscal controls. A fund should specify, at the outset, how its income will be spent, and an effective fiscal management system should be in place before withdrawals occur.

  • Clear investment goals. The investment managers must be benchmarked against clear financial targets. To that end, an ideal policy statement clarifies the overall objectives, asset allocations, risk tolerance (including views on diversification, rebalancing, and liquidity), and the measurement of performance.

  • Close scrutiny of costs and service providers. The committee should use only reputable providers, but also look for ways to minimize costs. This requires knowing what competitors charge; re-bidding contracts regularly; and enforcing contractual terms (firing poorly performing providers, if needed).

  • Maintenance of the real per capita value of the fund. Irrespective of any other goals, a trust fund must be able to preserve its real per capita value. If not, then it will eventually be depleted.

24. Here the priority should be to upgrade the governance structure. The trust fund and JTFC should take on a higher profile in Micronesia. This would include greater public discussion regarding the role of the trust fund and a clearer description of the challenges that Micronesia faces in 2023. These goals could be achieved by:

  • Delinking the JTFC from the committee implementing the Compact. Trust fund operations are different from the rest of the Compact, and effective oversight requires that the committee be staffed with professionals with financial expertise. This would also provide greater scope for local involvement.

  • Elevating the status of the JTFC through including the Secretary of Finance and Administration. This step would help highlight the fund’s importance for Micronesia’s future. Since the committee does not have a budget, the Secretary could also draw upon his or her staff to oversee the fund more effectively.

  • Aiming for greater openness regarding the operation and decisions of the JTFC. The annual report should be audited and published. Thereafter, the committee should aim to provide a quarterly report on the fund’s status. Future annual reports should analyze if there is a need for corrective action, by including a medium-term vulnerability analyses. Preferably, minutes should be published, and the members should meet with the public (including legislators) to explain the annual report.

25. Additional improvements could be made to the JTFC’s fiduciary practices. To strengthen accountability, the committee should explain its choice of advisors and their fees. Micronesia has yet to publish investment strategy or look at its investments, costs, and operations strategically. The committee’s operation would be improved by:

  • Adopting a simple and clear investment objective. The fund’s purpose is difficult to implement in practice.11 Instead, the committee could consider a simple mandate for the investment managers similar to other funds, such as to maximize returns while preserving the fund’s capita.

  • Examining the impact of a target of holding the fund’s balance at a real per capita level. While a real per capita target is not part of the agreement, the Micronesian government would come under fiscal pressure if it merely maintains a constant nominal value. An examination and publication of this information would help build support for early action to address the projected shortfalls.

F. Conclusion

26. Given the CTF’s importance, reforms are needed to raise the profile of its management committee and adopt a more strategic approach to investment. When Micronesia begins drawing down on the fund, it will represent a significant—if not the primary—source of funding for the government. However, the initial experience has been mixed, owing to a diffuse responsibility placed on the JTFC. By taking early measures to enhance the existing governance and fiduciary responsibilities, Micronesia can build public awareness of the importance of the fund and the challenges it faces. Providing more information is vitally important, but the current lack of awareness means that the committee’s reports are not likely to garner much attention. To that end, the committee members have an important role in educating the senior government officials, legislators, and the public at large about the Trust Fund. Such efforts are time consuming, but if reforms are enacted now, the Micronesian government will gain greater experience in managing and investing the fund, which should serve it well once the Compact expires.

References

  • FSM ONPA, 2006, “Inspection of the Compact Trust Fund,” Office of the National Public Auditor (ONPA) 2006–03, July.

  • FSM SSA, 2006, FSMSSA 2005 Annual Report (Pohnpei: FSM Social Security Administration) December.

  • FSM/US Trust Fund Agreement, 2002, available at: http://www.fm/jcn/docs/tfa.pdf.

  • GAO, 2003, Compacts of Free Association: An Assessment of the Amended Compacts and Related Agreements, GAO-03-890T (Washington: Government Accountability Office) June.

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  • GAO, 2006a, Compacts of Free Association: Development Prospects Remain Limited for Micronesia and Marshall Islands, GAO-06-590 (Washington: Government Accountability Office) June.

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  • GAO, 2006b, Compacts of Free Association: Micronesia and the Marshall Islands Face Challenges in Planning for Sustainability, Measuring Progress, and Ensuring Accountability, GAO-07-163 (Washington: Government Accountability Office) December.

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  • Graham, Benjamin, 2005, Trust Funds in the Pacific: Their Role and Future. Pacific Studies Series (Manila: Asian Development Bank).

  • JTFC, 2006, Annual Report: Trust Fund for the People of the Federated States of Micronesia (unpublished; Federated States of Micronesia: Joint Trust Fund Committee) March.

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  • NACUBO, 2003, NACUBO Endowment Study, National Association of College and University Business Officers (Washington: NACUBO).

  • Office of the Treasurer of the Regents, 2003, University of California Annual Endowment Report for the Fiscal Year ending June 30 (Oakland: University of California Regents).

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1

Prepared by Christopher Faulkner-MacDonagh (ext. 35978).

2

The Compact indexes payments using two-thirds of the annual increase in the U.S. GDP price deflator.

3

Other members may be added, as long as the United States retains a majority vote.

4

The trustee must also: (i) be a U.S.-based trust institution; (ii) have a net worth greater than $100 million; (iii) have at least ten years managing trust assets; and (iv) have experience managing trusts of at least $500 million. (FSM/US Trust Fund Agreement, 2002, Article 11, Section 3).

5

FSM/US Trust Fund Agreement, 2002, Article 14 (Section 1).

6

FSM/US Trust Fund Agreement, 2002, Article 17 (Section 3).

7

Many providers offer investments that follow these two indices. The Russell 3000 is an index fund of the shares of the 3,000 largest U.S. companies. The MSCI EAFE is Morgan Stanley Capital International’s index, covering equity markets in 21 industrialized economies in Europe, Australasia, and the Far East.

8

For 2007–11, U.S. Office of Management and Budget estimates GDP price inflation at 2¼ percent. For 2012–15, U.S. Congressional Budget Office estimates GDP price inflation at 1¾ percent per year, and this simulation assumes inflation is constant and equal to the rate in 2015.

9

Investment returns during the draw-down phase would likely be well-below those during the accumulation phase, because the government would need to shift its portfolio toward bonds and other less risky—and lower yielding—securities to preserve the fund’s principal.

10

Fees at U.S. university endowments average 40 basis points (NACUBO, 2003) for investment and custodial services, although this includes internally managed endowments. Charges for the externally-managed trusts for the University of California are higher, at 70 basis points (Office of the Treasurer of the Regents, 2003). The investment and custodial fees for the Micronesian Social Security System is 90 basis points (FSM SSA, 2006).

11

According to the Agreement, “the purpose of the Fund is to contribute to the economic advancement and long-term budgetary self-reliance of the Federated States of Micronesia by providing an annual source of revenue, after FY2023.” (FSM/US Trust Fund Agreement, 2002, Article 2).

Federated States of Micronesia: Selected Issues and Statistical Appendix
Author: International Monetary Fund
  • View in gallery

    CTF: Contributions and Balances

    U.S. and FSM contributions (by fiscal year, left axis) and Sum of past contributions and net earnings (right axis) (in millions of constant 2007 U.S. dollars)

  • View in gallery

    Impact of Investment Strategies

    Balance in the Compact Trust Fund (millions of constant 2007 U.S. dollars)