    Compacts of Free Association: Trust Funds for Micronesia and the
    Marshall Islands May Not Provide Sustainable Income (15-JUN-07,
    GAO-07-513).

    In 2003, the U.S. government extended its economic assistance to
    the Federated States of Micronesia (FSM) and Republic of the
    Marshall Islands (RMI) through Amended Compacts of Free
    Association. From 2004 to 2023, the United States will provide an
    estimated combined total of $3.6 billion, with annually
    decreasing grants as well as annually increasing contributions to
    trust funds for each country. The trust funds are to be invested
    and provide income for the FSM and RMI after the compact grants
    end. A trust fund committee for each country is to establish and
    oversee the funds. This report examines (1) the committees'
    progress in establishing, investing, and reporting on the funds;
    (2) the sustainability of income from the trust funds; and (3)
    potential options to supplement or enhance the trust funds'
    income. GAO reviewed trust fund-related documents and
    legislation; interviewed U.S., FSM, RMI, and industry officials
    and used a simulation model to project the trust funds' income.
    -------------------------Indexing Terms-------------------------
    REPORTNUM:   GAO-07-513
        ACCNO:   A70845
      TITLE:     Compacts of Free Association: Trust Funds for Micronesia
    and the Marshall Islands May Not Provide Sustainable Income
         DATE:   06/15/2007
      SUBJECT:   Federal aid to foreign countries
    	     Financial analysis
    	     Financial management
    	     Financial statements
    	     Foreign economic assistance
    	     Fund audits
    	     Funds management
    	     Grants
    	     International agreements
    	     Investment planning
    	     Reporting requirements
    	     Strategic planning
    	     Trust funds
    	     Compact of Free Association
    	     Federated States of Micronesia
    	     Republic of the Marshall Islands

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    GAO-07-513

         * [1]COMPACTS OF FREE ASSOCIATION
         * [2]Trust Funds for Micronesia and the Marshall Islands May Not

              * [3]Contents

         * [4]Appendix I Objectives, Scope, and Methodology 36
         * [5]Appendix II Technical Notes on the Trust Fund Simulation Mod
         * [6]Appendix III Disbursing All Income Compared to Disbursing Pa
         * [7]Appendix IV Key Events in the Establishment of the FSM and R
         * [8]Appendix V Comments from the Department of the Interior 53
         * [9]Appendix VI Comments from the Department of Health and Human
         * [10]Appendix VII Comments from the Department of State 62
         * [11]Appendix VIII Comments from the Federated States of Micrones
         * [12]Appendix IX Comments from the Republic of the Marshall Islan
         * [13]Appendix X GAO Contact and Staff Acknowledgments 73
         * [14]Tables
         * [15]Figures

              * [16]Results in Brief

                   * [17]Background

                        * [18]Trust Fund Contributions
                        * [19]Trust Fund Structure
                        * [20]Trust Fund Governance
                        * [21]Investment Returns and Volatility

                   * [22]Establishment of FSM Trust Fund Is Complete, but RMI
                     Trust F

                        * [23]Trust Fund Committees Have Taken Steps to Establish
                          and Inve
                        * [24]Several Factors Slowed Establishment of the Funds
                        * [25]Timing of Trust Fund Investment Reduced Potential
                          Earnings
                        * [26]Trust Fund Committees Did Not Publish Annual
                          Reports as Requ

                   * [27]FSM and RMI Trust Funds May Not Provide Sustainable
                     Income a

                        * [28]Market Volatility Could Lead to Wide Range of Trust
                          Fund Bal
                        * [29]Trust Funds May Not Provide Sustainable Income
                          after Compact

                             * [30]FSM Trust Fund Income
                             * [31]RMI Trust Fund Income

                   * [32]Several Options Exist for Supplementing FSM and RMI
                     Trust Fu

                        * [33]Greater Tax Revenue through Economic Development
                        * [34]Growing Emigration and Remittances
                        * [35]Economic Assistance from Other Donors
                        * [36]Trust Fund Securitization

                   * [37]Conclusions
                   * [38]Recommendations for Executive Action
                   * [39]Agency Comments and Our Evaluation

              * [40]Appendix I: Objectives, Scope, and Methodology
              * [41]Appendix II: Technical Notes on the Trust Fund Simulation Mo
              * [42]Appendix III: Disbursing All Income Compared to Disbursing P
              * [43]Appendix IV: Key Events in the Establishment of the FSM and
              * [44]Appendix V: Comments from the Department of the Interior

                   * [45]GAO Comment

              * [46]Appendix VI: Comments from the Department of Health and Huma

                   * [47]GAO Comment

              * [48]Appendix VII: Comments from the Department of State

                   * [49]GAO Comments

              * [50]Appendix VIII: Comments from the Federated States of Microne
              * [51]Appendix IX: Comments from the Republic of the Marshall Isla

                   * [52]GAO Comments

              * [53]Appendix X: GAO Contact and Staff Acknowledgments

                   * [54]GAO Contact
                   * [55]Staff Acknowledgments

                        * [56]Order by Mail or Phone

    Report to Congressional Committees

    United States Government Accountability Office

    GAO

    June 2007

    COMPACTS OF FREE ASSOCIATION

    Trust Funds for Micronesia and the Marshall Islands May Not Provide
    Sustainable Income

    GAO-07-513

    Contents

    Letter 1

    Results in Brief 3
    Background 6
    Establishment of FSM Trust Fund Is Complete, but RMI Trust Fund Is Not Yet
    Fully Established 15
    FSM and RMI Trust Funds May Not Provide Sustainable Income after Compact
    Grants End 20
    Several Options Exist for Supplementing FSM and RMI Trust Fund Income 28
    Conclusions 32
    Recommendations for Executive Action 32
    Agency Comments and Our Evaluation 33
    Appendix I Objectives, Scope, and Methodology 36
    Appendix II Technical Notes on the Trust Fund Simulation Model 38
    Appendix III Disbursing All Income Compared to Disbursing Partial Income
    48
    Appendix IV Key Events in the Establishment of the FSM and RMI Trust Funds
    51
    Appendix V Comments from the Department of the Interior 53
    GAO Comment 56
    Appendix VI Comments from the Department of Health and Human Services 57
    GAO Comment 60
    Appendix VII Comments from the Department of State 62
    GAO Comments 65
    Appendix VIII Comments from the Federated States of Micronesia 67
    Appendix IX Comments from the Republic of the Marshall Islands 69
    GAO Comments 72
    Appendix X GAO Contact and Staff Acknowledgments 73

    Tables

    Table 1: U.S. Assistance to the FSM and the RMI under Amended Compacts,
    Fiscal Years 2004-2023 7
    Table 2: Annual Compounded Real Returns and Standard Deviations for Large
    Company and International Stocks and for U.S. Treasury Bills (in
    percentage), 1970-2005 14
    Table 3: Possible Outcomes of Three Types of Investment Strategies, with
    Associated Real Returns and Standard Deviations 14
    Table 4: Projected Trust Fund Balances in 2023 with and without
    Securitization, under Aggressive Investment Strategy 31
    Table 5: U.S. Scheduled Contributions to FSM and RMI Trust Funds, as
    Outlined in Amended Compacts 38
    Table 6: Taiwan's Scheduled Contributions to RMI Trust Fund, as Outlined
    in Agreement with RMI Government 39
    Table 7: Real Returns Distribution Based on Historical Data from 1970 to
    2005 42
    Table 8: Cross-Correlation and Serial Correlation of Historical Annual
    Returns 43
    Table 9: Trial Values of the FSM Trust Fund Balances under Moderate
    Investment Strategy, Fiscal Years 2006-2023 44
    Table 10: Trial Values of the RMI Trust Fund Balance under Moderate
    Investment Strategy, Fiscal Years 2006-2023 46

    Figures

    Figure 1: Structure of FSM and RMI Trust Funds 10
    Figure 2: Inflation-Adjusted Annual Returns of International and Large
    Company Stocks, 1970-2005 13
    Figure 3: Timeline of Key Events in Establishment of FSM Trust Fund 16
    Figure 4: Timeline of Key Events in Establishing the RMI Trust Fund 17
    Figure 5: Projections of FSM Account Balance with Three Possible
    Investment Strategies 21
    Figure 6: Projections of RMI Account Balance with Three Possible
    Investment Strategies 22
    Figure 7: Probability of FSM Trust Fund Income Not Reaching the Maximum
    Disbursement Levels Allowed, Fiscal Years 2024 - 2050 24
    Figure 8: Probability of No Disbursement from FSM Trust Fund, Fiscal Years
    2024 - 2050 25
    Figure 9: Probability of RMI Trust Fund Income Not Reaching the Maximum
    Disbursement Levels Allowed, Fiscal Years 2024 - 2050 26
    Figure 10: Probability of No Disbursement from RMI Trust Fund, Fiscal
    Years 2024 - 2050 27
    Figure 11: Probabilities That FSM Trust Fund Income Will Not Reach the
    Maximum Disbursement Level Allowed When Disbursing All Income vs.
    Disbursing Partial Income 49
    Figure 12: Probabilities That RMI Trust Fund Income Will Not Reach the
    Maximum Disbursement Level Allowed When Disbursing All Income vs.
    Disbursing Partial Income 50
    Figure 13: Key Events in the Establishment of the FSM Trust Fund 51
    Figure 14: Key Events in the Establishment of the RMI Trust Fund 52

    Abbreviations

    FSM Federated States of Micronesia
    HHS Department of Health and Human Services
    RMI Republic of Marshall Island

    This is a work of the U.S. government and is not subject to copyright
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    its entirety without further permission from GAO. However, because this
    work may contain copyrighted images or other material, permission from the
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    separately.

    United States Government Accountability Office
    Washington, DC 20548

    June 15, 2007

    Congressional Committees:

    From 1987 to 2003,^1 the United States provided about $2.1 billion in
    economic assistance to the Federated States of Micronesia (FSM) and the
    Republic of the Marshall Islands (RMI) through a Compact of Free
    Association.^2 In 2003, the U.S. government extended its economic
    assistance to the FSM and the RMI governments through Amended Compacts of
    Free Association.^3 Under the amended compacts' terms, the United States
    will provide an estimated combined total of $3.6 billion in economic
    assistance to the FSM and the RMI from 2004 to 2023,^4 to assist the FSM
    and the RMI governments in their efforts to promote the economic
    advancement and budgetary self-reliance of their people. This assistance
    consists of annually decreasing grants targeted to certain development
    sectors and annually increasing contributions to a trust fund for each
    country, to which the FSM and the RMI are also to make initial
    contributions. The trust funds are to be invested, and after termination
    of annual U.S. grant assistance in 2023, annual disbursements of the
    investment earnings^5 are to provide an ongoing source of revenue to
    assist the FSM and the RMI in achieving economic advancement and long-term
    budgetary self-reliance.

    ^1In this report, all years cited are fiscal years (Oct. 1 - Sept. 30)
    unless otherwise noted.

    ^2A key goal for this assistance was to advance the countries' economic
    development and budgetary self-reliance. In 2000, we reviewed the impact
    of compact funding and found that U.S. assistance had resulted in little
    economic development for either the FSM or the RMI. See GAO, Foreign
    Assistance: U.S. Funds to Two Micronesian Nations Had Little Impact on
    Economic Development, [57]GAO/NSIAD-00-216 (Washington, D.C.: Sept. 22,
    2000).

    ^3Whereas the original compact (approved in Pub. L. No. 99-239, Jan. 14,
    1986) was one agreement among the U.S., FSM, and RMI governments, the
    amended compacts (approved in Pub. L. No. 108-188, Dec. 17, 2003) are
    separate agreements between the United States and each of the two
    countries.

    ^4The $3.6 billion in assistance includes (a) compact grants; (b) trust
    fund contributions; (c) Kwajalein impact funding provided to the RMI
    government, which in turn compensates Kwajalein Atoll landowners, for U.S.
    access to the atoll for military-purposes; and (d) estimated values of
    compact-authorized federal services such as weather, aviation, and postal
    services, at around $200 million over the 20-year period. Services
    associated with the Federal Emergency Management Agency have been
    excluded.

    ^5The annual disbursements may not exceed the amounts, adjusted for
    inflation, that each country receives as grant assistance in 2023.

    The amended compacts and subsidiary trust fund agreements^6 require the
    formation of a trust fund committee for each country. Each committee is
    responsible for establishing the trust funds by, among other things,
    hiring trustees, independent auditors, investment advisers and money
    managers. The trust fund committees' responsibilities also include
    overseeing the funds' operation, supervision, and management; the funds'
    investment; and the conclusion of agreements with any other contributors
    to the funds.^7 The trust fund agreements do not specify a time frame for
    establishing and investing the funds. Within 6 months after the end of
    each fiscal year, the committees are to provide annual reports to the
    governments on the trust funds' activities, management, financial
    operations, and effectiveness at accomplishing the purposes of the funds.
    Each committee comprises representatives from the U.S. government, the
    country's government, and any subsequent contributors; a representative
    from the Department of the Interior (Interior) serves as the chair of each
    committee.

    U.S. legislation approving the amended compacts requires that we report
    periodically to Congress on the status of compact implementation. In 2006,
    we provided two reports responding to this mandate.^8 This report provides
    additional information, examining (1) the trust fund committees' progress
    in establishing,^9 investing, and reporting on the funds; (2) the
    sustainability of income from the trust funds after the compact grants end
    in 2023; and (3) other potential sources of revenue to supplement or
    enhance trust fund income after 2023.

    ^6Agreement Between the Government of the United States of America and the
    Government of the Federated States of Micronesia Implementing Section 215
    and Section 216 of the Compact, as Amended Regarding a Trust Fund;
    Agreement Between the Government of the United States of America and the
    Government of the Republic of the Marshall Islands Implementing Section
    216 and Section 217 of the Compact, as Amended Regarding a Trust Fund.

    ^7Contributors other than the U.S., FSM, and RMI governments may include
    any government, international organization, financial institution, or
    other entity or person who contributes grants, not loans, to the trust
    funds.

    ^8GAO, Compacts of Free Association: Development Prospects Remain Limited
    for Micronesia and Marshall Islands, [58]GAO-06-590 (Washington, D.C.:
    June 2006); Compacts of Free Association: Micronesia and the Marshall
    Islands Face Challenges in Planning for Sustainability, Measuring
    Progress, and Ensuring Accountability, [59]GAO-07-163 (Washington, D.C.:
    Dec. 15, 2006). For an initial review of trust fund implementation, see
    GAO, Compacts of Free Association: Implementation of New Funding and
    Accountability Requirements Is Well Under Way, but Planning Challenges
    Remain, [60]GAO-05-633 (Washington, D.C.: July 11, 2005).

    To answer these objectives, we reviewed the amended compacts, the trust
    fund agreements and bank statements as well as documents related to
    establishing the funds. We also reviewed documents related to the
    implementation of the trust fund agreements. We interviewed officials from
    U.S. government agencies, including Interior, the Department of State
    (State), the Department of Labor (Labor), and the Department of Health and
    Human Services (HHS), as well as officials from the FSM and the RMI. We
    interviewed the RMI's trustee and selected investment adviser. In
    addition, we built a Monte Carlo simulation model--based on the trust fund
    agreements, contributions to date, and historical returns of the
    market--to project the trust funds' likely income levels, given market
    volatility as well as historical returns of various asset classes,
    including large company stocks, treasury bills, and international stocks
    from 1970 to 2005. (Actual trust fund income will depend on the investment
    strategies chosen for the funds, market trends, and investment
    performance.) We also analyzed the probability that the trust funds can
    maintain the maximum disbursement level allowed under the trust fund
    agreements.^10  We conducted our work from July 2006 to March 2007 in
    accordance with generally accepted government auditing standards. (For
    more details of our objectives, scope, and methodology, see app. I.)

    Results in Brief

    The FSM trust fund committee has fully established the country's trust
    fund, but the RMI trust committee has not; further, investment of the
    funds was slow, and both committees missed the deadlines for submitting
    the required annual reports. The FSM committee has appointed a trustee, an
    independent auditor, an investment adviser, and money managers. As of
    March 2007, the RMI committee had not appointed an independent auditor
    and--in part because the trustee and the investment adviser disagree over
    the assignment of custodial rights to the fund--had not appointed any
    money managers. Investment of the FSM and RMI trust funds began 22 months
    and 16 months, respectively, after the countries' initial contributions,
    with the funds remaining in low-interest savings accounts until their
    investment. According to U.S. government officials, unexpected contracting
    delays, as well as the trust fund committees' processes for reaching
    consensus and obtaining administrative support, contributed to slowing the
    funds' establishment. However, the committees have not taken steps to
    improve the processes. The committees did not meet the trust fund
    agreement requirements to submit and publish annual reports on the trust
    funds for 2004 and issued the reports for 2005 several months after the
    March 2006 deadline. Moreover, the reports do not assess the trust funds'
    likely effectiveness in helping the FSM and the RMI achieve economic
    advancement and long-term budgetary self-reliance by providing a source of
    revenue to the FSM and RMI governments after 2023.

    ^9In this report, "establishing the funds" refers to the selection and
    hiring of the trustees, independent auditors as well as the selection and
    hiring of any investment advisers and money managers.

    ^10According to U.S. officials, the trust fund income is intended to be
    one source of income, and the amended compacts do not guarantee that the
    trust funds will provide the maximum disbursements allowed by the trust
    fund agreements. However, projections of the trust funds' ability to
    disburse the maximum allowed amounts can indicate the likely level and
    sustainability of the funds' income.

    Owing in part to market volatility, the FSM and the RMI trust funds may
    not provide sustainable income to the countries after annual compact
    grants end in 2023. Market volatility, in addition to the investment
    strategies chosen, may lead to a wide range of trust fund balances in
    2023. For example, our analysis shows that the trust fund balance could
    range^11 from $697 million to $1.3 billion for the FSM and from $439
    million to $862 million for the RMI under a conservative strategy, from
    $663 million to $2.2 billion for the FSM and from $438 million to $1.4
    billion for the RMI under an aggressive strategy. Moreover, we found
    increasing probability that income from the trust funds cannot sustain the
    maximum disbursement level allowed--an amount equal to the compact grant
    assistance in 2023, adjusted for inflation. Furthermore, the trust funds
    face increasing probability of providing no income at all in some years.
    For instance, our analysis shows low probabilities that the trust funds
    will not reach the maximum allowed disbursement levels immediately after
    the compact grants end. However, by 2050, with a conservative investment
    strategy, income from the FSM and RMI trust funds, respectively, is more
    than 90 percent and 60 percent likely not to reach the maximum allowed
    disbursement levels and more than 20 percent and 15 percent likely to
    allow for no disbursements.

    ^11The ranges referred to in this example are between the 10th and 90th
    percentile values from the results of our simulation model under different
    scenarios. Ten percent of the range of possible trust balances lie below
    the 10th percentile; 90 percent of the range of possible balances lie
    below the 90th percentile. See appendixes I and II for more information.

    The trust funds' income could be supplemented or enhanced through (1)
    greater tax revenue through economic development; (2) increasing
    remittances from growing numbers of emigrants;^12 (3) economic assistance
    from other sources; and (4) securitization of the funds.^13 However, each
    of these scenarios has its limitations.

               o Greater tax revenue. Economic development could increase the FSM
               and the RMI governments' tax revenue. However, as we reported in
               2006, the countries' prospects for economic development and higher
               tax revenues remain limited.
               o Growing emigration and remittances. As compact grant assistance
               decreases, emigration from the FSM and RMI may rise, easing the
               governments' cost of providing services to remaining residents and
               possibly leading to growing remittances from the emigrants.
               However, FSM and RMI emigrants have limited earning opportunities
               abroad, owing to inadequate education and vocational skills, and
               may therefore not remit significant amounts.
               o Assistance from other sources. The RMI trust fund received a
               commitment from Taiwan to contribute $40 million over 20 years to
               the RMI trust fund, which improved the RMI fund's likely capacity
               for disbursements after 2023. However, except for Taiwan's
               commitment to the RMI, there is no certainty of external trust
               fund contributions other than those from the United States.
               Further, although donors other than the United States have given
               the two countries economic assistance unrelated to the trust
               funds, such assistance is not assured for the future.
               o Securitization. Although securitizing the trust funds--that is,
               issuing bonds against future U.S. contributions--could increase
               the funds' earning potential by raising their balances, it could
               also lead to lower balances and reduced income. According to
               Interior officials, the trust fund committees are reviewing this
               option but have not initiated an independent study to objectively
               evaluate its potential risks.

    ^12Remittances are personal funds that emigrants voluntarily send to
    residents in their home countries.

    ^13With securitization, the trust funds would sell bonds to investors and
    the cash generated through bond issuance would become the trust fund
    principal to be invested. Future contributions to the trust fund would be
    used to pay bond holders instead of building the funds. Securitization
    could help increase the principal of the trust fund more quickly than
    would annual contributions to the fund.

               In this report, we recommend that the Secretary of the Interior
               direct the Deputy Assistant Secretary for Insular Affairs, as
               Chairman of the FSM and the RMI trust fund committees, to develop
               strategies for improving the committees' decision-making and
               administrative processes; ensure timely reporting of trust fund
               activities, including assessment of the funds' likely status as an
               ongoing source of revenue and their potential effectiveness in
               helping the FSM and the RMI achieve economic advancement and
               budgetary self-reliance; and obtain an independent evaluation of
               the potential benefits and risks of securitization.

               Interior, HHS, State, and the FSM and the RMI governments provided
               written comments regarding a draft of this report. Interior, HHS,
               and the RMI government agreed with our recommendation on
               developing strategies for improving the trust fund committees'
               decision-making and administrative processes. Interior generally
               agreed with our recommendation on ensuring timely reporting of
               trust fund activities. However, HHS and State stated that our
               report reflected a fundamental misunderstanding of the outcome of
               the negotiation of the amended compacts and a misreading of the
               international agreements, which we strongly disagree. Our report
               clearly stated that the purpose of the trust funds is to provide
               an ongoing source of revenue. To further clarify this point, we
               modified our recommendation and added language specifying that
               there is no minimum disbursement required or guaranteed by the
               trust fund agreements. Interior, HHS, and the RMI government
               agreed with our recommendation on obtaining an independent
               evaluation of the potential benefits and risks of securitization.
               The FSM government generally agreed with all of our
               recommendations. State did not provide any comment about our
               recommendations.

    			  Background

               The U.S. trust fund agreements with the FSM and the RMI state that
               the purpose of the trust funds is to contribute to the countries'
               economic advancement and long-term budgetary self-reliance by
               providing an annual source of revenue after fiscal year 2023.^14
               Annual compact grants end in 2023. Although the agreements state
               that the annual disbursements may not exceed the amounts that each
               country receives as grant assistance in 2023, adjusted for
               inflation, they do not establish or guarantee a minimum
               disbursement level.

    ^14The trust fund income is intended to provide assistance in development
    sectors currently receiving grants under the amended compacts: education,
    health, infrastructure, private sector development, the environment, and
    public sector capacity building, with priority given to education and
    health. The income may also be used for other sectors mutually agreed to
    by the United States and the countries.

               Trust Fund Contributions

               Under the amended compacts, annual U.S. contributions to each of
               the countries' trust funds increase by the same amounts as the
               annual grants to the countries decrease; in addition, the
               contributions are partially adjusted for inflation. (See table 1.)
               However, the scheduled trust fund increments and grant decrements
               for the two countries differ: the grant decrement and trust fund
               increment for the FSM is $800,000 per year, and the grant
               decrement and trust fund increment for the RMI is $500,000 per
               year. The timing of the first decrement for each country also
               differs: under the amended compacts, the decrement for the FSM
               began in 2007, but the decrement for the RMI began in 2005. As a
               result of these differences, final grants to the FSM will decline
               from the initial grants by a smaller total percentage than will
               grants to the RMI (18 percent versus 21 percent).

               Table 1: U.S. Assistance to the FSM and the RMI under Amended
               Compacts, Fiscal Years 2004-2023

    Dollars in millions
                   Annual grants contribution  Trust fund contribution
    Fiscal year            FSM         RMI         FSM            RMI
    2004                 $76.2       $35.2       $16.0           $7.0
    2005                  76.2        34.7        16.0            7.5
    2006                  76.2        34.2        16.0            8.0
    2007                  75.4        33.7        16.8            8.5
    2008                  74.6        33.2        17.6            9.0
    2009                  73.8        32.7        18.4            9.5
    2010                  73.0        32.2        19.2           10.0
    2011                  72.2        31.7        20.0           10.5
    2012                  71.4        31.2        20.8           11.0
    2013                  70.6        30.7        21.6           11.5
    2014                  69.8        32.2        22.4           12.0
    2015                  69.0        31.7        23.2           12.5
    2016                  68.2        31.2        24.0           13.0
    2017                  67.4        30.7        24.8           13.5
    2018                  66.6        30.2        25.6           14.0
    2019                  65.8        29.7        26.4           14.5
    2020                  65.0        29.2        27.2           15.0
    2021                  64.2        28.7        28.0           15.5
    2022                  63.4        28.2        28.8           16.0
    2023                  62.6        27.7        29.6           16.5
    Total             $1,401.6      $629.0      $442.4         $235.0

               Source: Compact of Free Association Amendments Act of 2003 (Pub.
               L. No. 108-188).

               Note: These dollar amounts will be adjusted each year for
               inflation by a percentage that equals two-thirds of the percentage
               change in the U.S. gross domestic product implicit price deflator,
               or 5 percent, whichever is less in any one year, using the
               beginning of 2004 as a base. Both grant funding and trust fund
               contributions can be fully adjusted for inflation after 2014 under
               certain U.S. inflation conditions.

               The U.S. contributions to the trust funds are conditioned on the
               FSM and the RMI making their own required contributions. The FSM
               was required to contribute at least $30 million before September
               30, 2004; the FSM made this contribution on October 1, 2004, and
               the United States made its first contribution on October 5, 2004.
               The RMI was required to contribute at least $25 million on the day
               the amended compact went into effect or on October 1, 2003,
               whichever was later; $2.5 million before October 1, 2004; and an
               additional $2.5 million before October 1, 2005. The RMI made its
               initial contribution on June 1, 2004, and the United States made
               its initial contribution on June 3, 2004.

               According to the U.S. trust fund agreements with the FSM and the
               RMI, contributions from other donors are permitted. In May 2005,
               Taiwan and the RMI reached an agreement that Taiwan will
               contribute a total of $40 million to the RMI's trust fund from
               2004 to 2023.

    			  Trust Fund Structure

               As specified in the trust fund agreements, each country's trust
               fund consists of three interrelated accounts, labeled "A," "B,"
               and "C."^15

    ^15A "D" account may be established to hold any contributions by the FSM
    and the RMI governments of revenue or income from unanticipated sources.
    According to the trust fund agreements, the D account must be a separate
    account, not mixed with the rest of the trust fund; it is not part of the
    corpus of the trust fund. As of March 2007, only the RMI had a D account,
    governed by the agreement between Taiwan and the RMI. Taiwan will
    contribute $10 million to the RMI's D account in 5 years.

               o The A account, which was to be created on the amended compacts'
               effective date, forms the trust fund "corpus"^16 and contains the
               country's initial contributions as well as the annual U.S.
               contributions. It also holds any contributions from other donors,
               such as Taiwan's to the RMI. The A account additionally consists
               of income from the trust fund's investment. Through 2022, any
               annual investment income exceeding 6 percent of the fund will be
               deposited in the C account, up to a certain limit. After 2023, if
               the income in the B account is less than the previous year's
               distribution, and if the C account cannot cover the shortfall in
               the B account, the corpus shall not be accessed to compensate for
               the shortfall.
               o The B account, which is to be created at the start of fiscal
               year 2023, will be used to disburse income after the compact
               grants end. All annual investment income earned in 2023 will be
               deposited in the B account for possible disbursement in 2024.
               Thereafter, the B account will consist of the prior year's
               investment income in the A account. The annual disbursement from
               the B account may equal, but not exceed, the inflation-adjusted
               grant assistance in 2023 plus any additional amounts for special
               needs agreed to by the trust fund committee. Any amount exceeding
               the annual disbursement will be transferred back to the A account
               or--if the C account contains less than three times the estimated
               equivalent of 2023 grant assistance, including estimated
               inflation--transferred to the C account to bring it to the maximum
               level allowed.
               o The C account, which was to be created at the same time as the A
               account, is designed as a buffer against low or negative annual
               investment returns after 2023. During the period before
               disbursements begin, any annual income on the fund exceeding 6
               percent will be deposited in the C account; however, the C account
               cannot exceed three times the estimated grant assistance in 2023,
               including estimated inflation. After 2023, if annual income from
               the A account falls below the previous year's distribution,
               adjusted for inflation, the C account can be drawn down to address
               any shortfall in the B account.

    ^16According to the trust fund agreements, "corpus" means a collection of
    bonds, stocks, or other holdings that form the principal of the trust
    fund. It also includes all accumulated income that has been reinvested and
    is not available for distribution.

    Figure 1: Structure of FSM and RMI Trust Funds

    Trust Fund Governance

    The trust funds, incorporated in the District of Columbia as nonprofit
    corporations, are governed by the FSM and the RMI trust fund committees,
    with the United States holding the majority of votes and the Deputy
    Assistant Secretary of the Interior, Office of Insular Affairs, serving as
    the chair of each committee.^17 The committees' responsibilities^18
    include establishing the funds as well as overseeing their operation,
    supervision, and management; investing and distributing the fund's
    resources; and concluding agreements with any other contributors and other
    organizations.

    According to the trust fund agreements, each trust fund committee is to
    appoint a trustee and an independent auditor. In addition, the committee
    has the authority to appoint one or more investment advisers and may enter
    into a separate agreement with one or more money managers.

               o The trustee19 is to have the entire care and custody of all
               assets comprising the trust fund. The trustee's duties and powers
               include collecting money due to the fund, disbursing income in
               accordance with the trust fund agreement, and maintaining records
               of all financial transactions related to the fund.
               o The independent auditor is to audit the trust fund from its
               establishment through 2023 at appropriate intervals and annually
               after 2023.
               o The investment adviser is responsible for recommending one or
               more money managers who will invest the assets of the fund to
               produce a diversified portfolio, take direction from the trust
               fund committee regarding investments, and oversee day-to-day
               investments by the money manager.

    ^17Except for where stated otherwise in the agreement, trust fund
    committee decisions are made by a majority vote. The FSM trust fund
    committee has five voting members: three from the United States (Interior,
    State, and HHS) and two from the FSM. The RMI trust fund committee has
    seven voting members: four from the United States (Interior, State, HHS,
    and Labor); two from the RMI; and one from the other contributor, Taiwan.

    ^18Each agreement states that either the U.S. government, in consultation
    with the FSM or the RMI government, or the trust fund committee, if it is
    operational when the amended compact takes effect, is responsible for
    establishing the trust fund. (In this case, "establishing the trust fund"
    refers to the incorporation of the fund rather than to the selecting and
    hiring of the trustee, auditor, investment adviser, and money manager, as
    the phrase is otherwise defined in this report.)

    ^19The trust fund agreements states that the trustee shall (a) be selected
    from among trust institutions organized in the United States, (b) have a
    net worth in excess of $100 million, (c) have at least 10 years experience
    as a custodian of financial assets, and (d) have experience in managing
    trust funds of at least $500 million.

               o The money manager is to invest the funds in particular
               investment vehicles or categories.

               The trust fund agreements do not specify a time period for
               selecting these entities.

               In addition, the committees are responsible for publishing annual
               reports on the trust funds and submitting the reports to the
               governments of United States and the FSM or the RMI within 6
               months after the end of each fiscal year--that is, by the end of
               the following March. These reports are to describe the activities
               and management of the funds, including the operation of the A, B,
               and C accounts, and to contain audited account information and the
               audit reports. The reports are also to assess the effectiveness of
               the funds in contributing to the economic advancement and
               long-term budgetary self-reliance of the FSM and RMI. The reports
               may include recommendations to improve the effectiveness of the
               funds.^20

    Investment Returns and Volatility

               Because the level of income that the trust funds will generate
               depends on investment returns, it is subject to market volatility.
               Historically, the stock market has experienced fluctuations. For
               example, from 1970 to 2005, annual inflation-adjusted returns of
               U.S. large-company stocks ranged from negative 34 percent to
               positive 34 percent, and annual real returns from international
               stocks ranged from negative 31 percent to positive 68 percent (see
               fig. 2). With positive returns, the trust funds will earn
               investment income, and with negative returns, the value of the
               trust funds will fall.

    ^20In addition, Pub. L. No. 108-188 requires the President to report
    annually to Congress regarding the FSM and the RMI, including information
    on non-U.S. contributions to the trust funds and, if appropriate, making
    recommendations to Congress to adjust the inflation rate or to adjust
    contributions to the trust funds based on non-U.S. contributions.

    Figure 2: Inflation-Adjusted Annual Returns of International and Large
    Company Stocks, 1970-2005

    Note: The returns were published in Stocks, Bonds, Bills and Inflation
    (SBBI) 2006 Yearbook, Ibbotson Associates, Chicago, Illinois. The
    inflation-adjusted returns are the geometric difference between the
    nominal return and the inflation rate. Our calculation is based on returns
    in calendar years (Jan. 1 - Dec. 31).

    The annual compounded real returns^21 of large company stocks and
    international stocks from 1970 to 2005 were around 6 percent (see table
    2), with standard deviations^22 of approximately three times the return
    for the large company stocks and more than three times the return for the
    international stocks. U.S. treasury bills have the least volatility and
    the lowest returns, around 1 percent.

    ^21To calculate the compounded real returns, we used the annual total
    nominal returns published in IBBOTSON Associates 2006 Yearbook and
    constructed the inflation adjusted returns, which is a geometric
    difference between the nominal return and the inflation rate. We then
    constructed the real and nominal return indexes with year end 1969 = $1.00
    to calculate the annual compounded returns.

    ^22Standard deviation is a statistical measure of how widely spread the
    distribution is from its mean. It is obtained by calculating the square
    root of the average of the squares of deviations around the mean of a set
    of data.

    Table 2: Annual Compounded Real Returns and Standard Deviations for Large
    Company and International Stocks and for U.S. Treasury Bills (in
    percentage), 1970-2005

                              Large company                         U.S. Treasury
                                     stocks International stocks            bills
    Compounded real                 6.12                 6.18             1.27
    returns
    Standard deviation             17.09                22.05             2.50

    Source: GAO analysis of data from IBBOTSON Associates 2006 Year Book.

    Note: Percentages shown are based on returns in calendar years (Jan. 1 -
    Dec. 31).

    Investment strategies vary in their levels of returns and volatility. A
    more conservative investment strategy usually carries a lower level of
    volatility but also brings lower levels of expected returns over time; a
    more aggressive investment strategy seeks higher returns but is likely to
    have higher volatility, with returns on the investment varying more widely
    year to year. By varying the weight of each investment asset, investors
    can vary their return and risk levels. With the approach of 2024, when
    disbursements from the trust funds will begin, the portfolio can be
    adjusted to take on less risk. To illustrate possible outcomes of the
    trust funds' investment returns, table 3 shows potential returns for three
    types of investment strategies--conservative, moderate, and
    aggressive--based on historical annual compounded returns and volatility
    on large company stocks, international stocks, and treasury bills in 1970
    to 2005.

    Table 3: Possible Outcomes of Three Types of Investment Strategies, with
    Associated Real Returns and Standard Deviations

                                    Large
                                  company International Treasury         Standard
    Strategy                    stocks        stocks    bills Return deviation
    Conservative (Lower
    expected return/lower
    volatility)                    40%           20%      40%  4.19%    10.48%
    Moderate (Medium expected
    return/medium volatility)       40            40       20   5.17     14.18
    Aggressive (Higher
    expected return/higher
    volatility)                     50            50        0   6.15     17.53

    Source: GAO analysis of data from IBBOTSON Associates 2006 Year Book.

    Note: Percentages shown are based on returns in calendar years (Jan. 1 -
    Dec. 31).

    Establishment of FSM Trust Fund Is Complete, but RMI Trust Fund Is Not Yet Fully
    Established

    The FSM trust fund committee has appointed a trustee, an independent
    auditor, an investment adviser, and money managers; investment of the FSM
    trust fund began 22 months after the country's contribution. The RMI trust
    fund committee has appointed a trustee and an investment adviser, but as
    of March 2007, it had not yet appointed an auditor-- in part because of
    disagreement between the trustee and investment adviser over the assigning
    of custodial rights--nor had it appointed a money manager. Investment of
    the RMI's trust fund began 16 months after the country's initial
    contribution. Unexpected delays related to contractual problems and trust
    fund committee processes contributed to the time that elapsed between the
    countries' initial contributions and the investment of the funds.
    Moreover, the period of time that the funds remained in low-interest
    accounts before their investment may have reduced potential investment
    earnings, particularly for the FSM. The committees did not meet the trust
    fund agreements' requirements to submit and publish annual reports on the
    funds for 2004 and were late in publishing the 2005 and 2006 reports.
    Moreover, the reports did not assess the trust funds' potential status as
    an ongoing source of revenue or effectiveness in helping the FSM and the
    RMI achieve economic advancement and long-term budgetary self-reliance.

    Trust Fund Committees Have Taken Steps to Establish and Invest the Funds

    The FSM trust fund committee has appointed a trustee, an independent
    auditor, an investment adviser, and money managers. The RMI trust fund
    committee has not officially appointed an auditor or a money manager.
    Investment of the funds began in August 2006 and September 2005,
    respectively.

               o FSM. The FSM trust fund committee hired a trustee, an auditor,
               an investment adviser, and a money manager 24, 33, 16, and 21
               months, respectively, after the amended compact went into effect.
               Investment of the FSM trust fund, according to its adopted
               investment policy, did not begin until August 2006, nearly 2 years
               after the FSM's initial contribution to the trust fund. Figure 3
               provides a timeline of key events in setting up the FSM trust
               fund. (For details about this timeline, see app. IV).

    Figure 3: Timeline of Key Events in Establishment of FSM Trust Fund

    Note: The years shown are calendar years (Jan. 1 - Dec. 31).

               o RMI. The RMI trust fund committee hired its current trustee and
               investment adviser in August 2005, 16 months after the amended
               compact went into effect. However, as of March 2007, the committee
               had not yet hired an independent auditor. In addition, owing to a
               disagreement between the trustee and the adviser over the
               assigning of custodial rights, the committee had not yet hired
               money managers to actively invest the funds according to the
               proposed investment strategy.^23 The trust fund agreements state
               that the trustee shall have the entire care and custody of all
               assets comprising the fund, however, the investment adviser has
               requested "subcustody" to allow it to better monitor the money
               managers' adherence to the investment strategy. The RMI trustee
               has not agreed to this arrangement, stating in a letter to the
               trust fund committee chairman that the trust fund agreement does
               not allow such an arrangement without legislation to amend the
               trust fund agreement. U.S. officials told us that they had been
               searching for a resolution of this dispute. Although the RMI made
               its first contribution of $25 million in June 2004, a month after
               the trust fund agreement went into effect, the country did not
               make its second contribution until February 2005--almost 5 months
               after the deadline--when it contributed $1.5 million, which was $1
               million less than required.^24  The RMI government explained that
               it faced various financial challenges in 2005, including the cost
               of upgrading infrastructure at the College of the Marshall
               Islands.^25 The committee transferred the RMI trust fund from
               low-interest bank accounts and began to invest it at the end of
               September 2005, 16 months after the initial contribution to the
               trust fund. In May 2005, Taiwan contributed $1 million to help
               fulfill RMI's second contribution requirement, and in October
               2005, the RMI made the final contribution of $2.5 million. Figure
               4 provides a timeline of key events in setting up the RMI trust
               fund. (For details of the timeline of key events, see app. III.)

    ^23The adviser has not billed the committee as of March 2007.

    Figure 4: Timeline of Key Events in Establishing the RMI Trust Fund

    Note: The years shown are calendar years (Jan. 1 - Dec. 31).

    Several Factors Slowed Establishment of the Funds

    Unexpected contractual delays, as well as the trust fund committees'
    decision-making and administrative processes, slowed the committees'
    establishment of the funds.

               o Contractual delays. Unexpected contractual delays slowed the FSM
               and the RMI trust fund committees' establishment of the funds. For
               example, according to an Interior official, the trustee chosen by
               the FSM trust fund committee provided the wrong template for its
               contract with the committee, with the result that finalizing the
               contract took extra time. Also, a disagreement over fees between
               the RMI trust fund committee and its initially selected trustee
               led the committee to select another trustee, delaying the RMI's
               contracting with a trustee.

    ^24The amended compacts required the RMI to contribute at least $25
    million on the effective date of the trust fund agreement or in October
    2003, whichever was later; $2.5 million prior to October 1, 2004; and $2.5
    million prior to October 1, 2005.

    ^25The College of the Marshall Islands has experienced accreditation
    problems since 2003. According to the President of the college, the
    accreditation committee requires evidence that the college's physical
    infrastructure will be substantially upgraded. The RMI government had to
    find funding for the needed improvements and now has a plan for improving
    the college's infrastructure.

               o Trust fund committee processes. Delays related to certain trust
               fund committee processes also contributed to the time required to
               establish the funds. The U.S. members make it a practice to
               convene to reach consensus before attending full committee
               meetings. However, according to an Interior official, difficulty
               in convening all U.S. members has often delayed full committee
               meetings for months. Also, Interior noted that the trust fund
               committees' reliance on U.S. government staff for administrative
               support slowed committee processes. U.S. government employees have
               undertaken administrative functions for the trust funds in
               addition to their other duties. Interior, which has provided
               administrative support for the trust funds, has advocated that the
               trust funds hire their own support staff;^26 however, State has
               argued that after the trust funds are fully established, such
               positions would not be needed and would result in unnecessary
               costs. Some trust fund committee officials acknowledged that the
               committee processes have slowed the funds' establishment. However,
               the committees have not developed strategies to improve the
               consensus process and have not reached agreement about whether
               they should hire outside administrative assistance to improve
               committee performance.

    			  Timing of Trust Fund Investment Reduced Potential Earnings

               Although the trust fund agreements do not set a time frame for
               investing the funds, the months when the funds remained in
               low-interest accounts prior to investment may have reduced their
               potential investment earnings. However, the reduction in potential
               earnings was significant only for the FSM trust fund.

               o FSM. For several months before the FSM trust fund was invested,
               stock market returns were notably higher than the interest that
               the fund earned in the low-interest savings account. From October
               2005 through August 2006, the FSM trust fund--with an October 2005
               balance of approximately $80 million--earned about 3 percent
               interest, compared with potential stock market earnings of about
               15 percent. The difference between the fund's actual and potential
               monthly rates of return was about nine-tenths of a percentage
               point, amounting to approximately $720,000 per month, taking into
               account stock market investment fees. After the FSM's Office of
               the Public Auditor issued a report evaluating the trust fund
               committee's compliance with the administrative requirements of the
               trust fund agreement,^27  the FSM government expressed concerns
               over the reduced income resulting from the fund's remaining in the
               savings account.

    ^26Interior believes that an administrative support position is allowed
    under the trust fund agreements and its cost can be covered by the trust
    funds.

    ^27FSM Office of the Public Auditor, Inspection of the Compact Trust Fund:
    Period Covering August 2004 until May 2006 (Pohnpei, FSM, 2006).

               o RMI. For the months before the investment of the RMI trust
               fund's approximately $49 million in October 2005, the fund earned
               a return of approximately 3 percent, compared with a stock market
               return of about 4 percent. Given the small difference in returns,
               as well as the fees that the fund would have paid if invested in
               the stock market, the reduction in the RMI trust fund's potential
               income was small. We estimate that the delay in the RMI's final
               contribution to the fund reduced its earnings by approximately
               $51,000.^28

    ^28To estimate the RMI's income loss from late contributions, we
    calculated (a) the lost interest income on $25 million between May 2004,
    the contribution deadline, and June 2004, when the RMI made its first
    contribution; (b)the lost interest income on $2.5 million between October
    2004, when the RMI was supposed to make its second contribution, and
    February 2005, when it made a partial contribution; and (c) the lost
    interest income on $1 million between February 2005, when the RMI
    contributed $1.5 million for its second contribution, to May 2005, when
    the RMI contributed the remaining $1 million. We used the actual interest
    rate the RMI trust fund earned during the period.

    			  Trust Fund Committees Did Not Publish Annual Reports as Required

               Neither trust fund committee provided an annual report to the U.S.
               and FSM or RMI governments as required in the first year after the
               compacts took effect, and both committees were late in submitting
               the second year's reports.^29 According to the trust fund
               agreements, the committees are to prepare a report for each fiscal
               year and submit it to both the U.S. and the FSM or RMI governments
               by the end of the following March. However, neither committee
               submitted a report for fiscal year 2004, instead submitting one
               report for both 2004 and 2005. Additionally, the FSM and the RMI
               committees submitted these reports several months after the March
               2006 deadline, in July 2006 and August 2006, respectively.
               Moreover, the reports do not project the likely status of the
               trust funds as an ongoing source of revenue or assess the funds'
               potential effectiveness in helping the countries achieve economic
               advancement and budgetary self-reliance.^30 Because the trust fund
               income will be a main source of U.S. assistance to the FSM and the
               RMI after the amended compact grants end, its level has
               implications for the economic policies of both countries. For
               example, if trust fund income is expected to be inadequate to
               replace the expiring grants, the countries will have a greater
               need to develop other sources of revenue to help fund government
               operations.

    ^29The International Monetary Fund (IMF) has called for disclosing
    publicly the objectives and performance of the trust fund in line with the
    IMF guidelines for a transparent framework to ensure accountability and
    clarity of the trust fund management activities and results. See
    International Monetary Fund, RMI: Selected Issues and Statistical
    Appendix, IMF Country Report No. 06197 (Washington, D.C.: March 2006).

               FSM and RMI Trust Funds May Not Provide Sustainable Income after
    			  Compact Grants End

               The FSM and the RMI trust fund income will likely not reach the
               maximum allowed disbursement levels after the compact grants end
               in 2023, with the probability of not reaching the maximum allowed
               level increasing over time.^31 Variable market returns, as well as
               the investment strategy chosen, could lead to a wide range of
               potential trust fund balances in 2023. Moreover, market volatility
               could contribute to not reaching the maximum level allowed,
               including the possibility of no disbursements in some years.^32

    ^30This information could be included in the President's annual reports to
    Congress required by Pub. L. No. 108-188. The legislation does not require
    that information such as projections of trust fund balances be included in
    the reports. However, its inclusion would provide additional insight
    regarding the FSM's and RMI's progress in formulating economic policies to
    achieve economic advancement and budgetary self-reliance, to which the
    trust funds are intended to contribute by providing a source of revenue to
    the FSM and the RMI after 2023. The level of the trust fund income is
    directly related to its effectiveness in helping the countries achieve
    self-reliance: the higher the trust fund income, the more likely the
    countries will be self-reliant.

    ^31The probability that disbursements will not reach the maximum
    disbursement level allowed depends on the actual approved disbursement
    levels. For example, if the trust fund committees do not disburse all
    earned income and instead reinvest part of the income, the probability of
    disbursements not reaching the maximum disbursement level allowed will
    differ from the probabilities presented below. (For a comparison of the
    probabilities of disbursements not reaching the maximum disbursement level
    allowed with and without full disbursement, see app. III.)

    ^32In addition to market volatility, the amount of contributions to the
    trust funds plays an important role in determining whether the trust funds
    are able to provide sustainable income. Additional contributions to the
    funds improve the prospect of sustainability. For information on how
    Taiwan's contributions enhanced trust fund sustainability, see section on
    Economic Assistance from Other Donors.

    			  Market Volatility Could Lead to Wide Range of Trust Fund Balances
    			  in 2023

               Given historical market returns and volatility, the trust funds'
               likely balances in 2023 fall into a wide range, with a more
               aggressive strategy leading to higher expected balances but also a
               wider range of possible balances (see fig. 5 and 6). For example,
               under our projected conservative strategy, in 2023, the FSM trust
               fund balance could range from $697 million (10th percentile) to
               $1.3 billion (90th percentile) with a median of $959 million; the
               RMI trust fund could range from $439 million (10th percentile) to
               $862 million (90th percentile) with a median of $612 million.
               Under our projected aggressive strategy, the FSM trust fund
               balance could range from $664 million (10th percentile) to $2.2
               billion (90th percentile) with a median of $1.2 billion; the RMI
               trust fund balance could range from $438 million (10th percentile)
               to $1.4 billion (90th percentile) with a median of $778 million.

    Figure 5: Projections of FSM Account Balance with Three Possible
    Investment Strategies

    Figure 6: Projections of RMI Account Balance with Three Possible
    Investment Strategies

    Trust Funds May Not Provide Sustainable Income after Compact Grants End

    The FSM and the RMI trust funds may be unable to disburse the maximum
    level of income allowed in the trust fund agreements^33 or any income at
    all in some years.^34 Although each trust fund has a separate account to
    absorb some market volatility, our analysis shows there are some
    probabilities that income will not reach the maximum disbursement level
    allowed or that no income will be disbursed in some years, with the
    likelihood increasing with time.

      FSM Trust Fund Income

    Under the conservative, moderate, and aggressive investment strategies
    that we projected, the FSM trust fund's annual income will probably not
    reach the maximum disbursement allowed, with the probability increasing
    with time. For example, our analysis shows more than 50 percent
    probability that the trust fund's income will not reach the maximum
    disbursement level allowed after 2031 under the conservative investment
    strategy, with the probability over 90 percent by 2050 (see fig. 7).

    ^33The trust fund agreements specify that in 2024 and thereafter, the FSM
    and the RMI trust fund committees may disburse amounts up to the annual
    grant assistance in 2023, fully adjusted for inflation, provided that
    funds are available in the B account to reach such level. In 2025 and
    thereafter, the disbursements may also include any additional approved
    amounts for special needs.

    ^34Our analysis shows that to maintain the maximum disbursement levels
    allowed for 10 years without risk, the FSM and the RMI trust funds need to
    earn compounded real returns of around 13 percent and 9 percent through
    2023, respectively. However, these percentages are considerably higher
    than the stock market's compounded real returns from 1970 to 2005 of
    around 6 percent for both international stocks and U.S. large company
    stocks. If the trust funds are not in risk free treasury bonds and earn
    higher returns after 2023, the required returns for the funds before 2023
    will be lower; however, the trust funds will be subject to market
    volatilities.

    Figure 7: Probability of FSM Trust Fund Income Not Reaching the Maximum
    Disbursement Levels Allowed, Fiscal Years 2024 - 2050

    Moreover, our analysis shows an increasing probability that market
    volatility could prevent the FSM trust fund from making any disbursements
    in some years, although a separate account--the C account--was set up to
    absorb some market volatility. As shows, under the conservative investment
    strategy, the probability of no disbursements grows from 0 percent in 2024
    to over 20 percent in 2050 (see fig. 8).

    Figure 8: Probability of No Disbursement from FSM Trust Fund, Fiscal Years
    2024 - 2050

    Note: The chart depicts results from 1,000 trial runs. The change from one
    year to the next may not always be monotonic, but the general time trend
    is clear. As the number of trial runs increase, the time trend becomes
    smoother.

    Our analysis shows a wide range of probable disbursements from the FSM
    trust fund. For example, under the moderate investment strategy, 10 years
    after the trust fund starts to disburse income, we find a 57 percent
    probability that the trust fund will disburse the maximum level of income
    allowed, which is estimated at $97 million for 2034; a 11 percent
    probability that the trust fund will disburse no income; and a 33 percent
    probability that the trust fund will disburse some income, between $0 and
    $97 million.

      RMI Trust Fund Income

    Under the three potential investment strategies, income from the RMI trust
    fund is likely not to reach the maximum allowed disbursement, with the
    probability increasing over time. For example, our analysis shows a more
    than 20 percent probability that the trust fund's income will not reach
    the maximum allowed disbursement after 2031 under the conservative
    strategy, with the probability over 60 percent by 2050 (see fig. 9).

    Figure 9: Probability of RMI Trust Fund Income Not Reaching the Maximum
    Disbursement Levels Allowed, Fiscal Years 2024 - 2050

    Note: This analysis includes Taiwan's contribution to the A account.

    Additionally, our analysis shows an increasing probability that the RMI's
    trust fund could yield no disbursements in some years, despite the
    existence of the C account to absorb some market volatility. As figure 10
    shows, under the conservative investment strategy, the probability of no
    disbursements rises from 0 percent in 2024 to more than 15 percent in 2050
    (see fig. 10).

    Figure 10: Probability of No Disbursement from RMI Trust Fund, Fiscal
    Years 2024 - 2050

    Notes: This analysis includes Taiwan's contribution to the A account. The
    chart depicts results from 1,000 trial runs. The change from one year to
    the next may not always be monotonic, but the general time trend is clear.
    As the number of trial runs increase, the time trend becomes smoother.

    Our analysis shows a wide range of probable disbursements from the RMI
    trust fund. For example, under the moderate investment strategy, 10 years
    after the trust fund starts to disburse income, we find an 84 percent
    probability that the trust fund will disburse the maximum level of income
    allowed, which is estimated at $43 million for 2034; a 4 percent
    probability that the trust fund will disburse no income; and a 12 percent
    probability that the trust fund will disburse some income, between $0 and
    $43 million.

    Several Options Exist for Supplementing FSM and RMI Trust Fund Income

    The FSM and the RMI trust funds' income could be supplemented or enhanced
    by (1) greater tax revenue through economic development in the two
    countries, (2) increased remittances from growing numbers of emigrants,
    (3) economic assistance from other donors, and (4) securitization of the
    funds.^35 However, each possible scenario has limitations. In particular,
    although securitization could lead to higher trust fund balances in 2023,
    it also has the potential to lower investment income, reducing the
    balances.

    Greater Tax Revenue through Economic Development

    Economic development in the FSM and the RMI could increase the countries'
    tax revenue, helping to supplement the income from the trust funds.
    However, as we reported in 2006, the countries' development prospects
    remain limited--despite U.S. compact assistance since 1987, aimed at
    promoting economic advancement and budgetary self-reliance--and as a
    result, greater tax revenue may not be feasible.^36  Both countries'
    economies depend on public sector expenditure, funded largely by external
    assistance; in 2005, public sector expenditures--about two thirds of which
    were funded by grants--were about 60 percent of the gross domestic
    product. Further, both governments' budgets face growing wage
    expenditures, heightening the negative fiscal impacts they will face as
    compact grants decline. In both countries, the growth of key industries
    faces multiple constraints. Further, as we also reported in 2006, the FSM
    and the RMI have not undertaken many reforms needed for economic
    development.

    Growing Emigration and Remittances

    Growing emigration from the FSM and the RMI could help reduce the
    countries' reliance on the trust fund income: as the countries'
    populations decline, the governments' need for trust fund income to
    provide services would also decline. FSM and RMI residents can relocate to
    the United States relatively easily owing to rights granted under the
    original compact and extended by the amended compacts.^37  Many FSM and
    RMI citizens have chosen to exercise these rights: RMI data suggest that
    as of 2005, about 15,000 Marshallese had migrated to the United States,
    and FSM data suggest that almost twice as many Micronesians live overseas.
    In both countries, the likely effects of decreasing levels of per capita
    grant assistance may cause emigration to increase.

    ^35Through securitization, the trust fund sells bonds to investors, and
    the cash generated through bond issuance will become the trust fund
    principal to be invested. Future contributions to the trust fund will be
    used to pay bond holders before being available as income to the trust
    fund. Securitization helps build up the principal of the trust fund right
    away rather than slowly by annual contributions to the fund.

    ^36GAO-06-590.

               o FSM. If the FSM population maintains its 2004 level,^38 real per
               capita grant assistance in 2023, the last year of compact grants,
               will be about 73 percent of assistance in 2004, the first year of
               compact grants. Furthermore, even with the aggressive investment
               strategy we projected, the trust fund income is likely to be lower
               than the compact grant, continuing the declining trend in
               government resources. As a result, FSM living standards, including
               the availability of social services, will likely be reduced,
               potentially leading to further emigration.
               o RMI. Per capita grant assistance in the last year of compact
               grants will be about 70 percent of assistance in the first year if
               the RMI population maintains its 2004 level. Given the aggressive
               investment strategy, per capita trust fund income in 2024 and
               thereafter may equal per capita grant assistance in 2023. However,
               if trust fund income is unreliable, as our analysis shows likely,
               RMI living standards, including the availability of social
               services, will probably be affected, possibly leading to increased
               emigration.

               If increasing numbers of FSM and RMI residents choose to emigrate
               in the coming years as annual compact grants decrease, remittances
               from growing numbers of emigrants could supplement residents'
               income and, if taxed, could provide revenue to the FSM and the RMI
               governments. However, it is not certain that remittances would
               grow significantly or lead to increased government revenues.
               Although FSM and RMI emigrants could provide increasing monetary
               support to their home nations, inadequate education and vocational
               skills may limit their earning opportunities. As we reported in
               2006, the 2003 U.S. census of FSM and RMI migrants in Hawaii,
               Guam, and the Commonwealth of the Northern Mariana Islands shows
               that almost half of them live below the poverty line. However,
               some economic experts emphasize that with an upgrading of skills,
               the FSM's and the RMI's free access and strong historical links to
               the U.S. economy create potential for the two nations to expand
               remittance income.^39

    ^37Under the original compacts, citizens from the FSM and the RMI had the
    right to live and work in the United States as "nonimmigrants" and to stay
    for long periods of time. Although the amended compacts strengthened
    immigration provisions, these rights were generally extended for citizens
    as defined under the amended compacts.

    ^38Owing to emigration, growth of the FSM population has slowed from about
    2 percent in the early 1990s to virtually zero since 1995.

    ^39Experts also suggest that in addition to increasing income from
    emigrant remittances, returning emigrants may bring back newly acquired
    skills and capital that could support growth in the home economy. See
    GAO-06-590; also see Francis X. Hezel, Is That the Best You Can Do? A Tale
    of Two Micronesian Economies (Honolulu: East-West Center, Pacific Islands
    Policy, 2006).

               Economic Assistance from Other Donors

               Economic assistance, including contributions to the FSM and the
               RMI trust funds, from external sources other than the United
               States could lessen the countries' reliance on trust fund income.
               For example, our analysis shows that Taiwan's contribution of $40
               million to the RMI's trust fund reduced by nearly 10 percent the
               probability that the trust fund not reaching the maximum
               disbursement level allowed in 2050. However, it is not certain
               whether the FSM trust fund will receive any such contributions or
               whether the RMI trust fund will receive any further contributions.
               Further, although both countries have previously received other
               economic assistance from donors besides the United States--for
               example, from the Asian Development Bank, Australia, and
               Japan--assistance in the future is not assured.

    			  Trust Fund Securitization

               Securitization of the trust funds--that is, issuing bonds against
               future U.S. contributions to the funds--has the potential to
               increase the funds' balances. The benefit from securitization
               would mainly derive from arbitrage, or potential differences in
               returns on investment and returns on the bonds issued to
               investors: the greater the differential, the greater the benefit
               from securitization.

               However, although securitization of the trust funds carries
               potential benefits, our analysis shows that its introduction could
               subject the funds to greater risk. Because the full trust fund
               amounts would be invested after securitization, loss from
               securitization in the early years could lead to smaller investment
               income and trust fund balances in later years. Our analysis shows
               that securitization could result in a wider range of possible
               trust fund balances at the amended compacts' expiration (see table
               4). For example, under the possible aggressive investment
               strategy, securitization could result in an FSM trust fund balance
               of $579 million (10th percentile) to approximately $2.7 billion
               (90th percentile), with a median of $1.3 billion; without
               securitization, the trust fund balance could range from $664
               million (10th percentile) to approximately $2.2 billion (90th
               percentile), with a median balance of about $1.2 billion.^40
               Securitization could result in a similarly wider range of balances
               and larger median balance for the RMI trust fund.

               Table 4: Projected Trust Fund Balances in 2023 with and without
               Securitization, under Aggressive Investment Strategy

    			  Dollars in millions
                                  FSM                            RMI
    Trust fund
    balance                                                With
    distribution            With        Without                        Without
    statistics    securitization securitization  securitization securitization
    10th
    percentile              $579           $664            $390           $438
    Median                 1,314          1,182             845            778
    90th
    percentile             2,700          2,179           1,688          1,401
    Standard
    deviation                912            647             590            422

               Source: GAO.

               According to officials of the FSM and the RMI trust fund
               committees, the committees are considering securitizing the funds
               but disagree over whether this option should be pursued. Some
               members believe that securitization could bring great financial
               benefits, as a company that performs securitization has asserted
               in presentations to the committees; other members are concerned
               about potential risks. Others raise concerns of whether the trust
               funds could pursue securitization under the current amended
               compacts and trust fund agreements or whether amendments to these
               agreements would be required. The committees have not initiated an
               independent analysis to assist in their decisions.

    ^40Under different investment strategies, the range of possible fund
    balances will be different. However, securitization will still lead to a
    wider range of possible fund balances. Securitization can lead to a higher
    expected balance when the investment returns are higher than the rate the
    funds pay to its bond holders.

               Conclusions

               Since the enactment of the amended compacts with the FSM and the
               RMI, the trust fund committees have taken important steps to
               establish the funds. However, the committees' decision-making and
               administrative processes slowed the funds' establishment and
               investment, leading to lower potential investment earnings for the
               FSM. Until the committees develop strategies to improve these
               processes, their ability to take timely actions regarding the
               funds will likely be impeded. In addition, the committees'
               tardiness in publishing the required annual reports limited the
               public availability of information regarding the trust funds'
               establishment and the committees' oversight. Further, the reports
               do not assess the potential status of the funds as an ongoing
               source of revenue after the compact grants end. Given the likely
               effects of market volatility on the funds' investment earnings,
               such assessments are needed to help the countries develop other
               strategies for achieving the compact goals of economic advancement
               and long-term budgetary self reliance. Both countries have several
               options to supplement trust fund income after 2023, but these
               options have limitations and are not assured of success. Although
               the trust fund committees are considering one of these
               options--securitization--to increase the funds' balances, they
               have not yet initiated an independent analysis of securitization's
               potential benefits and risks, including the possibility that
               securitization could lead to lower trust fund balances in 2023.

    			  Recommendations for Executive Action

               To enhance the FSM and the RMI trust fund committees' oversight of
               the trust funds, we recommend that the Secretary of the Interior
               direct the Deputy Assistant Secretary for Insular Affairs, as
               Chairman of the committees, to work with other U.S. agencies on
               the committees to undertake the follow three actions:

               o develop strategies to improve the timeliness of the committees'
               decision-making and administrative processes;
               o ensure the committees' timely reporting of trust fund
               activities, including assessing the funds' likely status as a
               source of revenue and effectiveness in helping the countries
               achieve economic self-sufficiency and long-term budgetary
               self-reliance; and
               o obtain a full and independent evaluation of the potential
               benefits and risks of using securitization to increase the trust
               fund balances.

    			  Agency Comments and Our Evaluation

               We received written comments from Interior, HHS, and State as well
               as from the FSM and RMI governments (see app. V through IX for
               detailed presentations of, and our responses to, these comments).
               We also received technical comments from State, which we
               incorporated in our report as appropriate. We did not receive any
               comment from Labor.

               Interior, HHS, and the RMI government concurred with our first
               recommendation. Interior also generally concurred with our second
               recommendation. However, HHS and State stated that our report
               reflected a fundamental misunderstanding of the outcome of the
               negotiation of the amended compacts and a misreading of the
               international agreements, which we strongly disagree. Our report
               clearly stated that the purpose of the trust funds is to provide
               an ongoing source of revenue. To further clarify this point, we
               modified our recommendation and added language specifying that
               there is no minimum disbursement required or guaranteed by the
               trust fund agreements. We believe that careful analysis of the
               trust funds each year will help establish realistic expectations
               of the trust funds and provide information to the trust fund
               committees as they make investment decisions and to FSM and RMI
               government leaders as they set economic policies and undertake
               long-term fiscal planning. Interior, HHS, and the RMI government
               agreed with our third recommendation. The RMI noted that it would
               like the trust fund contributions to be fully adjusted for
               inflation. The FSM government in general agreed with all of our
               recommendations.

               In addition to providing copies of this report to your offices, we
               will send copies to interested congressional committees. We will
               also provide copies of this report to the Secretaries of Health
               and Human Services, the Interior, Labor and State as well as the
               President of the Federated States of Micronesia and the President
               of the Republic of the Marshall Islands. We will make copies
               available to others on request. In addition, the report will be
               available at no charge on the GAO Web site at
               http://www.gao.gov .

               If you or your staff have any questions regarding this report,
               please contact me at (202) 512-3149 or gootnickd@gao.gov .
               Contact points for our offices of Congressional Relations and
               Public Affairs may be found on the last page of this report. GAO
               staff who made major contributions to this report are listed in
               appendix X.

               David Gootnick
    			  Director, International Affairs and Trade

               List of Congressional Committees

               The Honorable Jeff Bingaman
    			  Chairman
    			  The Honorable Pete V. Domenici
    			  Ranking Member
    			  Committee on Energy and Natural Resources
               United States Senate

               The Honorable Joseph R. Biden, Jr.
    			  Chairman
    			  The Honorable Richard G. Lugar
    			  Ranking Member
    			  Committee on Foreign Relations
    			  United States Senate

               The Honorable Nick J. Rahall, II
    			  Chairman
    			  The Honorable Don Young
               Ranking Member
    			  Committee on Natural Resources
    			  House of Representatives

               The Honorable Tom Lantos
    			  Chairman
    			  The Honorable Ileana Ros-Lehtinen
    			  Ranking Member
    			  Committee on Foreign Affairs
    			  House of Representatives

    			  Appendix I: Objectives, Scope, and Methodology

               In this report on the trust funds established under the U.S.
               government's amended compacts with the Federated States of
               Micronesia (FSM) and the Republic of the Marshall Islands (RMI),
               we examine (1) the trust fund committees' progress in
               establishing, investing, and reporting on the funds; (2) the
               sustainability of income from the trust funds after the compact
               grants end in 2023; and (3) other potential sources of revenue to
               supplement or enhance trust fund income after 2023.

               To review the trust fund committees' progress in establishing,
               investing, and reporting on the funds, we reviewed the amended
               compacts, trust fund agreements; annual trust fund reports for
               2004 and 2005 by the trust fund committee, trust fund bank
               statements, and documents related to the request for proposals to
               set up the trust funds. We interviewed officials from the
               Departments of the Interior, Health and Human Services, Labor, and
               State. We also interviewed relevant RMI and FSM officials and
               representatives from companies involved in setting up, investing,
               and managing the trust funds.

               To project the trust fund income level after the U.S. annual
               compact grants end, we obtained historical returns of various
               asset classes, including large company stocks, international
               stocks, and U.S. treasury bills, from 1970 to 2005 and built a
               projection model based on the historical returns, contributions to
               the trust fund, and rules governing the disbursement from the
               trust fund as outlined in the trust fund agreements. We used the
               inflation projection by the Congressional Budget Office to adjust
               the contribution and grant levels (see app. II for a detailed
               discussion on the key inputs to the projection model). We used a
               solver function in our projection model to find the minimum level
               of return between 2007 and 2023 required, so that the trust fund
               income equals the 2023 grant level plus full inflation for at
               least the first 10 years after trust fund disbursements begin. For
               this calculation, we assumed the trust funds will be put into U.S.
               treasury bonds after 2023. To assess the impact of market
               volatility on the trust fund income, we used the Monte Carlo
               simulation with computer-generated random draws from a predefined
               distribution, based on the historical returns and volatilities of
               the various asset classes. Each random draw produces a possible
               outcome of the variables we are interested in, such as the balance
               of the trust fund and the level of disbursement in a particular
               year; 1,000 random draws generates 1,000 possible outcomes. We
               studied the distribution of the outcomes to determine, for
               instance, the probability that the trust funds' annual
               disbursements will be below the maximum allowed disbursement
               levels. Probabilistic projection of the trust funds' income is an
               improvement over the methodology based on constant returns because
               investment returns are volatile.

               To examine other potential sources of revenue to supplement the
               trust fund income, we reviewed studies on the economic conditions
               in the FSM and the RMI. We also reviewed studies examining
               emigration of the FSM and RMI citizens. To examine the potential
               benefit and risks of securitization, we modified the simulation
               model and compared the trust funds' balance in 2023 with and
               without securitization. We assumed the bond issued by the trust
               fund pays an annual return of 5.5 percent.^1

               To ensure the soundness of our projection, we obtained and
               incorporated technical comments on the simulation assumptions and
               methodology from Interior and the investment adviser of the FSM
               trust fund.

               We conducted our review from July 2006 to March 2007 in accordance
               with generally accepted government auditing standards. We
               requested written comments on a draft of this report from the
               Departments of the Interior, Health and Human Services, and State
               as well as the governments of the FSM and the RMI. All of these
               entities' comments are discussed in the report and are reprinted
               in appendix V through IX. In addition, we considered all technical
               comments and made changes to the report, as appropriate.

    ^1This number is based on our conversation with an industry expert.

               Appendix II: Technical Notes on the Trust Fund Simulation Model

               The key inputs that we used to simulate the trust fund income
               after 2023 include (1) the trust funds' balances at the beginning
               of the projection, (2) contributions to the trust funds, (3)
               inflation adjustment to the contributions, (4) different accounts
               of the trust funds and the rules governing the inter-account
               transfers, (5) the simulation equation; (6) distribution of
               returns for the Monte Carlo simulation, and (7) Monte Carlo
               simulation results.

                            1.  Trust fund balance at the beginning of the
                            projection

               As of September 30, 2006, the FSM trust fund had a balance of
               $86.53 million and the RMI trust fund had a balance of $63.14
               million.

                            2.  Contributions to the trust fund

               Table 5 shows scheduled contributions to the FSM and the RMI trust
               funds by the United States, as outlined in the amended compacts.
               Table 5 shows scheduled contributions to the RMI trust fund by
               Taiwan, as outlined in its agreement with the RMI.

               Table 5: U.S. Scheduled Contributions to FSM and RMI Trust Funds,
               as Outlined in Amended Compacts

    Dollars in millions
                                 U.S. contribution
    Fiscal year         FSM trust fund RMI trust fund
    2004                           $16             $7
    2005                            16            7.5
    2006                            16              8
    2007                          16.8            8.5
    2008                          17.6              9
    2009                          18.4            9.5
    2010                          19.2             10
    2011                            20           10.5
    2012                          20.8             11
    2013                          21.6           11.5
    2014                          22.4             12
    2015                          23.2           12.5
    2016                            24             13
    2017                          24.8           13.5
    2018                          25.6             14
    2019                          26.4           14.5
    2020                          27.2             15
    2021                            28           15.5
    2022                          28.8             16
    2023                          29.6           16.5

               Source: Public Law 108-188.

               Table 6: Taiwan's Scheduled Contributions to RMI Trust Fund, as
               Outlined in Agreement with RMI Government

    Dollar in millions
    Fiscal year Contribution to A account Contribution to D account
    2004                            $1.00                     $3.00
    2005                             0.75                      1.75
    2006                             0.75                      1.75
    2007                             0.75                      1.75
    2008                             0.75                      1.75
    2009                             2.40                      0.00
    2010                             2.40                      0.00
    2011                             2.40                      0.00
    2012                             2.40                      0.00
    2013                             2.40                      0.00
    2014                             2.40                      0.00
    2015                             2.40                      0.00
    2016                             2.40                      0.00
    2017                             2.40                      0.00
    2018                             2.40                      0.00
    2019                             2.40                      0.00
    2020                             2.40                      0.00
    2021                             2.40                      0.00
    2022                             2.40                      0.00
    2023                             2.40                      0.00

               Source: Subsequent Contributor Accession Agreement between The
               Trust Fund Committee Established by the Government of the United
               States of America, and the Government of the Republic of the
               Marshall Islands Implementing Section 216 and Section 217 of the
               Compact, as Amended and Taiwan.

               Note: Our projection included Taiwan's contribution to the A
               account, but not the D account because it is a separate account
               from the rest of the trust fund.

                            3.  Inflation adjustment

               The compact grants and the U.S. trust fund contributions are
               adjusted for inflation by a percentage that equals the lesser, in
               any year, of two-thirds of the percentage change in the U.S. gross
               domestic product implicit price deflator or 5 percent, using the
               beginning of 2004 as a base. Both grant funding and trust fund
               contributions can be fully adjusted for inflation after 2014 under
               certain U.S. inflation conditions.

                            4.  Trust fund accounts and transfer rules

               The trust fund agreements allow for several types of transfers
               among the A, B, and C accounts that we used in our projections.

               Before 2023:

               o From A to C. At the end of each year before disbursement starts
               in 2024, income exceeding 6 percent of the corpus shall be
               deposited in the C account. The C account cannot exceed three
               times the estimated equivalent of the fiscal year 2023 grant
               level, adjusted for inflation.
               o From C to A. Any amount in the C account exceeding three times
               the estimated equivalent of the fiscal year 2023 grant level,
               adjusted for inflation, shall return to the A account.

               Beginning in 2023:

               o From A to B. During 2023 and each subsequent year, all
               investment income will be transferred from the A account to the B
               account for possible disbursement in the following year.
               o From B to A or C. If the B account balance exceeds the annual
               grant assistance level in 2023 plus full inflation, the excess
               will be transferred to the A account. However, if the C account
               falls short of the specified level (three times the estimated
               equivalent of the 2023 grant level, inflation adjusted), any
               excess in the B account will be transferred to the C account to
               make up the shortfall.
               o From C to disbursement or A account. If the B account falls
               short of the previous year's disbursement, inflation adjusted, the
               C account can be drawn on to cover the shortfall. (The trust fund
               corpus may not be accessed for this purpose.) Any amount in the C
               account exceeding three times the estimated equivalent of the
               fiscal year 2023 grant level, adjusted for inflation, shall return
               to the A account.

               In our projection, we assume that the trust funds will disburse
               the maximum allowed amount if it is available. However, the trust
               fund committees may disburse less than the maximum amount allowed
               and reinvest some income. For a discussion of how partial
               disbursement can affect the probability of trust fund income not
               reaching the maximum disbursement level allowed (see app. III).

               5. Simulation equation

               For the Monte Carlo simulation of trust fund balances, we used the
               equation W_t+1= (W_t + C_t - AW_t)* (1+r_t)*(1-F_t), where

               W_t+1 = value of the fund at the beginning of year t+1

               W_t = value of the fund at the beginning of year t

               C_t = contribution to the fund at the beginning of year t

               r_t = the annual return in year t

               AW_t = the annual withdrawal in year t

               F_t = the fees as a percentage of account value the trust fund
               pays to its trustee, investment adviser, money managers, and
               lawyers, etc. (We assume the fees to be 1 percent of the account
               value.)

               6. Distribution of returns for Monte Carlo simulation

               The returns on the trust fund will be randomly drawn from a custom
               distribution, which is based on historical real returns of the
               various asset classes and the proportion of the asset in the
               investment strategy. The distributions for international stocks,
               large company stocks, and U.S. treasury bills are illustrated in
               table 7.

    Table 7: Real Returns Distribution Based on Historical Data from 1970 to
    2005

    International stocks              Large company stocks         U.S. treasury bills
         Range       Probability       Range       Probability      Range      Probability
    -30.61% -27.61%        2.86%  -34.47% -23.91%        2.86%  -3.74% -2.59%        2.86%
    -27.61   -22.41         2.86   -23.91  -21.56         2.86   -2.59  -1.99         2.86
    -22.41   -21.11         2.86   -21.56  -13.23         2.86   -1.99  -1.72         2.86
    -21.11   -17.62         2.86   -13.23  -13.07         2.86   -1.72  -1.70         2.86
    -17.62   -16.78         2.86   -13.07  -12.71         2.86   -1.70  -1.55         2.86
    -16.78   -15.17         2.86   -12.71  -12.09         2.86   -1.55  -1.13         2.86
    -15.17   -14.33         2.86   -12.09   -8.75         2.86   -1.13  -1.03         2.86
    -14.33    -9.15         2.86    -8.75   -2.27         2.86   -1.03  -0.84         2.86
    -9.15     -6.29         2.86    -2.27   -1.40         2.86   -0.84  -0.71         2.86
    -6.29     -4.55         2.86    -1.40   -1.32         2.86   -0.71  -0.43         2.86
    -4.55     -1.02         2.86    -1.32    0.79         2.86   -0.43   0.15         2.86
    -1.02      0.35         2.86     0.79    1.44         2.86    0.15   0.26         2.86
    0.35       2.94         2.86     1.44    2.23         2.86    0.26   0.42         2.86
    2.94       3.76         2.86     2.23    4.53         2.86    0.42   0.59         2.86
    3.76       5.25         2.86     4.53    4.64         2.86    0.59   0.98         2.86
    5.25       5.88         2.86     4.64    7.05         2.86    0.98   1.00         2.86
    5.88       8.79         2.86     7.05    7.37         2.86    1.00   1.02         2.86
    8.79       9.15         2.86     7.37   10.59         2.86    1.02   1.20         2.86
    9.15      10.25         2.86    10.59   11.87         2.86    1.20   1.60         2.86
    10.25     10.70         2.86    11.87   15.06         2.86    1.60   1.83         2.86
    10.70     11.85         2.86    15.06   16.89         2.86    1.83   1.85         2.86
    11.85     16.89         2.86    16.89   17.15         2.86    1.85   1.95         2.86
    16.89     18.42         2.86    17.15   17.81         2.86    1.95   2.25         2.86
    18.42     19.65         2.86    17.81   17.88         2.86    2.25   2.42         2.86
    19.65     20.05         2.86    17.88   18.03         2.86    2.42   2.46         2.86
    20.05     23.15         2.86    18.03   18.16         2.86    2.46   2.98         2.86
    23.15     23.18         2.86    18.16   19.12         2.86    2.98   3.20         2.86
    23.18     23.98         2.86    19.12   25.65         2.86    3.20   3.50         2.86
    23.98     26.94         2.86    25.65   26.33         2.86    3.50   3.55         2.86
    26.94     28.12         2.86    26.33   26.54         2.86    3.55   3.81         2.86
    28.12     29.38         2.86    26.54   26.67         2.86    3.81   4.82         2.86
    29.38     33.06         2.86    26.67   27.36         2.86    4.82   4.97         2.86
    33.06     36.60         2.86    27.36   28.21         2.86    4.97   5.30         2.86
    36.60     51.03         2.86    28.21   31.13         2.86    5.30   5.68         2.86
    51.03   68.04    2.86         31.13   34.03    2.86         5.68   6.42           2.86

    Source: GAO.

    Cross-correlation and serial correlation are built into the Monte Carlo
    random draws to capture the co-movement of the asset classes and over
    time. (See table 8.)

    Table 8: Cross-Correlation and Serial Correlation of Historical Annual
    Returns

                          International Large company U.S. treasury bills
    International                  1
    Large company               0.59             1
    Treasury bills             -0.12          0.05                   1
    Serial correlation          0.15          0.04                0.81

    Source: GAO.

    7. Monte Carlo simulation results

    Each year's return is randomly selected from the return distribution of
    each asset class. The simulation is run 1,000 times, yielding 1,000
    possible outcomes and providing a distribution of annual investment
    income, account balance, and disbursements. (Table 9 and table 10 show the
    first 20 trial values from the simulation of the FSM and RMI trust fund
    account balance.)

    Table 9: First 20 of the 1,000 Trial Values of the FSM Trust Fund Balances
    under Moderate Investment Strategy, Fiscal Years 2006-2023

    Dollars in millions
    Trial values      2006   2007   2008   2009   2010   2011   2012   2013
    1                $86.5 $133.3 $170.7 $192.8 $196.5 $167.5 $198.7 $236.5
    2                 86.5  107.5  154.0  194.2  251.4  328.3  332.6  323.1
    3                 86.5  93.51  138.4  176.0  230.4  267.3  290.0  312.7
    4                 86.5  129.6  181.4  188.3  210.6  202.1  250.6  295.4
    5                 86.5  121.5  134.4  148.5  182.6  275.5  386.8  474.9
    6                 86.5  128.8  124.2  124.4  151.0  155.3  216.6  253.4
    7                 86.5  122.6  140.2  192.4  202.7  225.3  327.1  358.3
    8                 86.5  109.1  112.7  174.9  250.4  247.4  256.1  346.3
    9                 86.5  103.5  140.3  174.8  205.3  256.2  269.1  333.7
    10                86.5  99.03  136.1  141.6  173.8  223.9  276.3  337.7
    11                86.5  109.5  180.9  214.1  248.7  228.9  330.3  368.2
    12                86.5  97.02  129.3  167.2  233.5  274.1  365.2  433.8
    13                86.5  91.73  112.9  157.1  204.7  253.1  327.4  388.0
    14                86.5  92.69  137.1  147.5  208.1  200.7  256.6  296.7
    15                86.5  99.15  107.0  114.7  139.2  207.4  265.7  359.9
    16                86.5  98.08  134.3  164.1  160.8  192.9  241.0  347.1
    17                86.5  108.0  147.3  195.2  246.9  358.8  464.1  461.7
    18                86.5  122.4  150.2  187.1  226.1  346.9  413.8  371.4
    19                86.5  116.2  138.9  202.0  218.2  268.0  300.9  270.6
    20                86.5  147.8  222.5  293.7  304.0  376.2  362.8  399.9
    10^th percentile  86.5  94.23  112.2  135.2  157.6  182.2  210.6  236.9
    median            86.5  111.6  139.2  171.5  206.3  244.1  288.9    331
    90^th percentile  86.5  128.3  169.3  213.8  261.4  323.8    387  455.5

         2014   2015   2016    2017    2018    2019    2020    2021    2022    2023
    $262.6 $291.6 $301.1  $288.9  $299.4  $282.1 $318.14 $349.58 $409.71 $545.09
        337.4  331.8  431.0   497.9   497.0   501.3  520.58   597.5  697.86  907.24
        426.2  496.6  522.3   517.4   695.7   842.4  724.48  807.41 1,150.4 1,223.6
        402.8  552.2  719.4   937.4 1,000.8 1,029.0 1,267.4 1,357.3 1,771.1    1708
        598.9  688.9  932.0   980.7   937.1 1,056.0 1,203.1 1,326.2 1,420.6 1,660.3
        349.2  412.0  471.1   569.9   606.2   614.3  768.84  926.91  907.27  932.03
        402.5  539.4  679.3   722.9   860.3 1,182.9 1,153.4 1,243.7 1,180.5  1212.3
        308.2  314.7  419.3   485.5   540.9   553.9   606.9  772.66  728.88  895.66
        447.0  513.0  523.3   619.4   614.1   692.9  758.54  811.66  808.01  943.09
        495.8  606.1  621.7   858.4   848.1   925.2 1,137.5 1,022.2 1,182.5  1507.2
        392.6  543.5  710.9     782   711.2   783.0  860.09  769.16  651.13  782.25
        472.3  436.6  484.6   541.4   530.7   655.9   705.5  806.55 1,164.4  1057.9
        503.8  432.6  504.2     581   535.0   687.2   772.5  987.18 1,038.2  1353.6
        382.2  443.1  471.2   600.2   764.5   819.6  803.22  925.79  865.13  959.52
        456.8  523.4  579.3   560.2   616.3   776.9    1003 1,112.8 1,211.2  1177.6
        417.3  449.1  424.7   398.9   361.4   484.6  593.15  689.94  817.63  858.45
        471.0  546.3  621.2     704   907.6 1,083.6  888.67 1,021.2 1,308.6 1,589.2
        489.0  519.9  677.1   752.7   901.5 1,151.8 1,072.1 1,535.1 1,668.8 1,970.0
        291.6  333.6  435.3   526.8   567.9  716.84  889.64 1,169.8 1,402.7 1,489.3
        569.8  752.8  931.8 1,149.0 1,467.0 1,466.6 1,727.6 2,193.6 2,290.8 2,525.2
        269.1  305.4  342.6   389.3  437.95  473.23  530.46  592.95  651.05  709.73
        379.3  433.7  501.8   563.4  643.53   717.1  798.43  910.03  1018.1  1107.9
        531.5  623.3  717.3   824.9  940.75  1079.6  1205.9  1351.4  1513.2  1723.9

    Source: GAO.

    Table 10: First 20 of the 1,000 Trial Values of the RMI Trust Fund Balance
    under Moderate Investment Strategy, Fiscal Years 2006-2023

    Dollars in millions
    Trial values      2006  2007   2008   2009   2010   2011   2012   2013
    1                $63.1 $83.4 $101.8 $143.4 $153.2 $191.4 $214.8 $280.8
    2                 63.1  91.8  123.5  134.3  178.3  201.3  253.5  327.6
    3                 63.1  73.4   93.8  114.0  159.7  190.5  194.0  242.6
    4                 63.1  78.0   78.5  102.0  114.0  144.3  126.4  125.9
    5                 63.1  77.9   89.0  106.7  131.3  178.0  211.1  261.9
    6                 63.1  79.5   96.9   98.0  100.0  120.5  128.1  157.6
    7                 63.1  77.9  118.9  131.5  125.8  160.8  214.1  243.7
    8                 63.1  69.5   93.7  119.8  134.1  175.2  205.5  231.0
    9                 63.1  73.7   96.9  126.2  147.7  179.7  196.2  216.4
    10                63.1  63.4   80.0  103.8  113.0  140.9  151.4  193.0
    11                63.1  75.7   86.6  136.6  163.2  172.0  204.4  237.7
    12                63.1  84.7  106.7  146.8  197.8  251.4  232.1  289.0
    13                63.1  80.0   98.7  110.2  111.1  140.1  207.6  220.5
    14                63.1  69.0   82.1   78.4   74.6   86.8  102.5  134.0
    15                63.1  66.1   87.3   78.4   93.0   99.7   98.3  116.4
    16                63.1  73.3   96.7   96.8  132.5  132.5  123.1  116.1
    17                63.1  75.7   90.1  114.7  115.6  155.0  204.3  268.1
    18                63.1  59.1   63.2   71.1   93.5  111.4  146.6  139.7
    19                63.1  90.7  110.1  119.9  160.1  167.6  242.4  301.3
    20                63.1  77.8   93.2  120.6  147.2  221.6  287.5  330.3
    10^th percentile  63.1  65.5   76.7   89.1  103.7  119.7  137.6  156.3
    median            63.1  78.5   95.5  114.9  137.3  161.6  185.5  214.3
    90^th percentile  63.1  89.4  114.7  145.7  177.1  212.8  252.6  299.7

         2014   2015   2016   2017    2018    2019    2020    2021    2022    2023
    $335.2 $369.3 $354.1 $401.7  $501.7  $568.5  $651.7  $604.2  $607.6  $579.2
        456.9  632.5  688.6  919.0 1,034.5 1,054.9 1,209.7 1,123.2 1,043.1  1102.8
        232.4  232.5  282.0  283.3   357.4   420.5   511.7   596.8   585.8   548.2
        156.1  145.7  213.3  278.4   283.4   366.5   340.7   314.0   345.2   819.4
        295.3  321.9  383.0  434.9   477.3   567.8   625.5   649.9   727.3   565.8
        196.6  169.7  175.4  250.3   323.5   401.3   370.2   469.6   508.9   979.4
        227.1  286.1  320.2  389.6   389.3   434.6   426.6   499.5   601.1 1,080.5
        315.0  375.9  433.4  504.2   564.2   617.8   528.1   683.9   752.1   786.8
        282.5  325.2  378.0  403.0   426.9   464.8   469.6   465.6   555.9   647.2
        252.5  317.3  278.8  344.6   429.7   469.7   455.9   570.9   732.0 1,436.0
        213.0  271.5  275.0  360.5   344.3   479.8   648.8   746.2   814.2   494.1
        351.3  314.2  313.6  355.0   386.6   436.3   626.0   659.0   785.0   582.3
        252.1  322.8  337.7  386.8   343.2   332.6   373.1   387.2   417.3   662.6
        150.9  170.7  216.6  287.2   342.5   380.5   447.7   479.6   489.5   701.3
        118.6  158.1  164.0  185.0   175.8   240.3   272.7   343.2   415.4   841.7
        170.9  215.8  270.7  354.6   451.1   471.3   471.3   554.4   506.4   602.2
        263.9  343.5  418.3  445.8   547.0   685.5   812.2   831.6   843.2   751.8
        149.1  204.0  266.5  282.8   242.7   307.0   302.8   410.9   496.1   936.0
        274.8  290.9  366.2  365.8   496.8   538.5   588.7   518.9   510.3   437.1
        360.1  397.7  335.6  432.7   404.9   398.8   409.4   468.7   532.8   521.0
        176.9  197.7  218.9  246.9   272.0   299.8   337.3   367.8   400.4   439.2
        247.1  280.5  315.2  357.7   402.3   451.1   495.4   556.3   611.9   676.5
        345.3  397.6  456.9  522.4   597.4   654.4   743.1   831.6   919.5 1,103.0

    Source: GAO.

    Appendix III: Disbursing All Income Compared to Disbursing Partial Income

    The U.S. trust fund agreements with the FSM and the RMI state that the
    trust fund committees may disburse an amount up to the inflation-adjusted
    grant assistance in fiscal year 2023. However, if the trust fund
    committees disburse less than the maximum allowed levels and reinvest part
    of the trust fund income, this will change the probability that the funds'
    income will not reach the maximum allowed disbursement levels.^1

    Figures 11 and 12, respectively, compare the probabilities, under our
    projected moderate investment strategy, of the FSM and the RMI trust fund
    income's not reaching the maximum disbursement level allowed when all
    income is disbursed versus when partial income is disbursed^. 2During the
    earlier years, the probability that income will not reach the maximum
    disbursement level allowed is generally greater when only partial income
    is disbursed. However, the probability that income will not reach the
    maximum disbursement level allowed is lower in later years, because the
    benefit of the reinvested trust fund income helps protect the trust fund
    principal against inflation.

    ^1According to 2005 study by the Asian Development Bank, a trust fund
    established with similar objectives for another Pacific island country,
    Tuvalu, reinvests trust fund income to maintain the fund's real value. The
    Tuvalu trust fund was established through a multilateral international
    agreement among Tuvalu, New Zealand, the United Kingdom, and Australia.
    See Benjamin Graham, Trust Funds in the Pacific, Their Roles and Future
    Manila, Philippines: Asian Development, 2005.

    ^2There are many different ways to disburse investment income partially.
    For example, the trust fund can disburse only income above inflation; the
    trust fund can reinvest to keep the corpus at a certain level before it
    starts to disburse any income. In this analysis, partial disbursement
    means disbursing income above inflation.

    Figure 11: Probabilities That FSM Trust Fund Income Will Not Reach the
    Maximum Disbursement Level Allowed When Disbursing All Income vs.
    Disbursing Partial Income

    Figure 12: Probabilities That RMI Trust Fund Income Will Not Reach the
    Maximum Disbursement Level Allowed When Disbursing All Income vs.
    Disbursing Partial Income

    Appendix IV: Key Events in the Establishment of the FSM and RMI Trust
    Funds

    Figure 13: Key Events in the Establishment of the FSM Trust Fund

    Figure 14: Key Events in the Establishment of the RMI Trust Fund

    Note: The years shown are calendar years (Jan. 1 - Dec. 31).

    Appendix V: Comments from the Department of the Interior

    Note: GAO comment supplementing those in the report text appears at the
    end of this appendix.

    See comment 1.

    Following is GAO's comment on the Department of the Interior's letter,
    dated May 11, 2007.

    GAO Comment

               1. We added clarification that no minimum disbursement from the
               trust funds is required or guaranteed. However, the trust fund
               agreements establish the 2023 level of compact grants, fully
               adjusted for inflation, as the maximum amount of annual income
               available for disbursement. Therefore, we believe it is
               appropriate to undertake a projection of the likely disbursements
               against that benchmark. We modified our second recommendation to
               emphasize that the reports should assess the status of trust fund
               performance and likely disbursements. We believe that careful
               analysis of the trust funds each year will help establish
               realistic expectations. Such analysis will also inform the trust
               fund committees as they make investment decisions and FSM and RMI
               leaders as they set economic policies and undertake long-term
               fiscal planning.

    Appendix VI: Comments from the Department of Health and Human Services

    Note: GAO comment supplementing those in the report text appears at the
    end of this appendix.

    Following is GAO's comment on the Department of Health and Human Services'
    letter, dated May 16, 2007.

    GAO Comment

               1. We strongly disagree with HHS' assertion that our report
               reflects a fundamental misunderstanding of the outcome of the
               negotiation of the amended compacts. We clearly stated the purpose
               of the trust funds is to provide an ongoing source of revenue for
               the FSM and the RMI. Furthermore, we added clarification that no
               minimum disbursement from the trust funds is required or
               guaranteed. However, the trust fund agreements establish the 2023
               level of compact grants, fully adjusted for inflation, as the
               maximum amount of annual income available for disbursement.
               Therefore, we believe it is appropriate to undertake a projection
               of the likely disbursements against that benchmark. We modified
               our second recommendation to emphasize that the reports should
               assess the status of trust fund performance and likely
               disbursements rather than the adequacy of the funds to ensure we
               do not imply any required level of minimum income. We believe that
               careful analysis of the trust funds each year will help establish
               realistic expectations. Such analysis will also provide
               information to the trust fund committees as they make investment
               decisions and to FSM and RMI leaders as they set economic policies
               and undertake long-term fiscal planning.

               HHS noted that "so long as the trust funds are a source of annual
               revenue at all, they have met their agreed and stated purpose."
               For the trust fund committees to be assured of achieving such a
               purpose, the trust funds would have to be invested in low-risk,
               low-yield government bonds after 2023. This would ensure that the
               trust funds will provide some level of disbursement to the FSM and
               the RMI. The income from the funds will not reach the maximum
               level of disbursement allowed and will diminish in real value over
               time. Our analysis shows that right after the grants expire, the
               funds will be able to disburse about 50 percent and 68 percent of
               the 2023 grant levels for the FSM and the RMI respectively with
               the ratios getting smaller over time.^1

    ^1We used the estimated median account balance in 2023 under the most
    aggressive strategy as a starting point for investment in government
    bonds.

    Appendix VII: Comments from the Department of State

    Note: GAO comments supplementing those in the report text appear at the
    end of this appendix.

    See comment 2.

    See comment 1.

    See comment 4.

    See comment 3.

    Following are GAO's comments on the Department of State's letter, dated
    May 15, 2007.

    GAO Comments

               1. We strongly disagree with State's assertion that our reading of
               the trust fund agreements is not justified by the terms of the
               agreements and is not consistent with the negations that lead to
               the agreements. We clearly stated the purpose of the trust funds
               is to provide an ongoing source of revenue for the FSM and the
               RMI. Furthermore, we added clarification that no minimum
               disbursement from the trust funds is required or guaranteed.
               However, the trust fund agreements establish the 2023 level of
               compact grants, fully adjusted for inflation, as the maximum
               amount of annual income available for disbursement. Therefore, we
               believe it is appropriate to undertake a projection of the likely
               disbursements against that benchmark. We modified our second
               recommendation to emphasize that the reports should assess the
               status of trust fund performance and likely disbursements rather
               than the adequacy of the funds to ensure we do not imply any
               required level of minimum income. We believe that careful analysis
               of the trust funds each year will help establish realistic
               expectations. Such analysis will also provide information to the
               trust fund committees as they make investment decisions and to FSM
               and RMI leaders as they set economic policies and undertake
               long-term fiscal planning.
               2. State commented that "so long as the trust funds are a source
               of annual revenue at all, they have met their agreed and stated
               purpose." For the trust fund committees to be assured of achieving
               such a purpose, the trust funds would have to be invested in
               low-risk, low-yield government bonds after 2023. This would ensure
               that the trust funds will provide some level of disbursement to
               the FSM and the RMI. The income from the funds will not reach the
               maximum level of disbursement allowed and will diminish in real
               value over time. Our analysis shows that right after the grants
               expire, the funds will be able to disburse about 50 percent and 68
               percent of the 2023 grant levels for the FSM and the RMI
               respectively with the ratios getting smaller over time.^1
               3. We disagree with State's characterizing our assessment of the
               trust funds' likely capacity to provide revenue to the governments
               of the FSM and the RMI as "likely to build up unwarranted
               expectations." On the contrary, we believe that careful analysis
               of the funds' probable income will help build realistic
               expectations and provide invaluable inputs for policymakers in
               formulating economic policies and long-term plans. It is to this
               end that we recommend that the trust fund committees assess the
               funds' status as an ongoing source of revenue and effectiveness in
               helping the countries achieve economic self-sufficiency and
               long-term budgetary self-reliance.
               4. State suggested a fifth strategy for enhancing the trust funds'
               income would e for the countries to allow the fund to grow further
               by refraining from requesting the withdrawal of the full allowable
               amount each year. We analyzed the option of not disbursing the
               maximum allowed income (see app. III). We compared the likelihood
               of not reaching the maximum level allowed when all income is
               disbursed versus when some income is reinvested. Our analysis
               shows while the benefit of the reinvested trust fund income helps
               improve the prospect of the trust funds in later years, the
               disbursement in earlier years will be lower.

    ^1We used the estimated median account balance in 2023 under the most
    aggressive strategy as a starting point for investment in government
    bonds.

    Appendix VIII: Comments from the Federated States of Micronesia

    Appendix IX: Comments from the Republic of the Marshall Islands Appendix
    IX: Comments from the Republic of the Marshall Islands

    Note: GAO comments supplementing those in the report text appear at the
    end of this appendix.

    See comment 2.

    See comment 1.

    Following are GAO's comments on the Republic of the Marshall Islands'
    letter, dated May 18, 2007.

    GAO Comments

               1. Our analysis was based on the current contribution structure.
               Under certain U.S. inflation conditions, contributions to the
               trust fund can be fully adjusted for inflation after 2014.
               2. Although the trust fund will have little or no impact on the
               RMI's economy until disbursements from the fund begin, we believe
               that careful analysis of the fund's likely income will help build
               realistic expectations and provide invaluable information for
               policymakers in formulating economic policies and long-term plans.
               It is to this end that we recommend that the RMI trust fund
               committee assess the fund's status as an ongoing source of revenue
               and effectiveness in helping the country achieve economic
               self-sufficiency and long-term budgetary self-reliance.

    Appendix X: GAO Contact and Staff Acknowledgments

    GAO Contact

    David Gootnick, (202) 512-3149 or gootnickd@gao.gov

    Staff Acknowledgments

    In addition to the individual above, Emil Friberg (Assistant Director) and
    Ming Chen made key contributions to this report. Muriel Brown, Lawrance
    Evans, Etana Finkler, Reid Lowe, Thomas McCool, Mary Moutsos, and Wilda
    Wong provided technical assistance.

    (320439)

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    www.gao.gov/cgi-bin/getrpt?GAO-07-513.

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    Highlights of GAO-07-513, a report to congressional committees

    June 2007

    COMPACTS OF FREE ASSOCIATION

    Trust Funds for Micronesia and the Marshall Islands May Not Provide
    Sustainable Income

    In 2003, the U.S. government extended its economic assistance to the
    Federated States of Micronesia (FSM) and Republic of the Marshall Islands
    (RMI) through Amended Compacts of Free Association. From 2004 to 2023, the
    United States will provide an estimated combined total of $3.6 billion,
    with annually decreasing grants as well as annually increasing
    contributions to trust funds for each country. The trust funds are to be
    invested and provide income for the FSM and RMI after the compact grants
    end. A trust fund committee for each country is to establish and oversee
    the funds. This report examines (1) the committees' progress in
    establishing, investing, and reporting on the funds; (2) the
    sustainability of income from the trust funds; and (3) potential options
    to supplement or enhance the trust funds' income. GAO reviewed trust
    fund-related documents and legislation; interviewed U.S., FSM, RMI, and
    industry officials and used a simulation model to project the trust funds'
    income.

    [69]What GAO Recommends

    GAO recommends that the trust fund committees improve administrative and
    decision-making processes, ensure timely reporting, and obtain a full and
    independent evaluation of securitization's potential benefits and risks.
    Interior, which chairs the committees, agreed with all of the
    recommendations.

    The FSM trust fund committee has established the fund by appointing a
    trustee, an auditor, an investment adviser, and money managers. As of the
    end of March 2007, the RMI committee had not appointed an auditor or a
    money manager. Investment of the funds began 22 months and 16 months,
    respectively, after the FSM's and RMI's initial contributions, with the
    funds remaining in low-interest savings accounts until their investment.
    Contractual delays contributed to the time taken to establish and invest
    the funds, as did the committees' processes for reaching consensus and
    obtaining administrative support; the committees have not yet taken steps
    to improve these processes. Although the committees are required to report
    annually on the trust funds, they did not publish reports for 2004 and
    were late in publishing the reports for 2005 and 2006. Moreover, the
    published reports do not assess the trust funds' potential effectiveness
    in helping the FSM and RMI achieve the compact goals of economic
    advancement and budgetary self-reliance.

    The FSM and RMI trust funds may not provide sustainable income after the
    compact grants end. Market volatility, as well as the investment
    strategies chosen, may lead to a wide range of trust fund balances in
    2023. There is increasing probability that in some years the trust funds
    will not reach the maximum disbursement level allowed--an amount equal to
    the inflation adjusted compact grants in 2023--or be unable to disburse
    any income. GAO's analysis shows low probabilities of not reaching the
    maximum level allowed or disbursing no income in 2024 but higher
    probabilities of not reaching the maximum level allowed in 2050. For
    instance, by 2050, with a conservative investment strategy, income from
    the FSM and RMI trust funds, respectively, is over 90 percent and 60
    percent likely to be less than the maximum level allowed and more than 20
    percent and 15 percent likely to allow for no disbursements.

    The trust funds' income could be supplemented or enhanced through (1)
    greater tax revenue, (2) increasing remittances from growing emigration,
    (3) economic assistance from other sources, and, possibly, (4)
    securitization of the funds. However, limited development prospects
    constrain the countries' ability to raise tax revenues to supplement the
    trust fund income. In addition, FSM and RMI emigrants' inadequate
    education and vocational skills may limit their earning opportunities.
    Further, although the RMI trust fund received contributions from Taiwan,
    it is unclear whether the FSM trust fund will receive other contributions.
    Finally, although securitization--the issuing of bonds against future U.S.
    contributions--could increase the funds' earning potential by raising
    their balances, it could also lead to lower balances and reduced income.
    The committees have not yet obtained an independent evaluation of
    securitization's potential benefits and risks.

    References

    Visible links
      57. http://www.gao.gov/cgi-bin/getrpt?GAO/NSIAD-00-216
      58. http://www.gao.gov/cgi-bin/getrpt?GAO-06-590
      59. http://www.gao.gov/cgi-bin/getrpt?GAO-07-163EUR
      60. http://www.gao.gov/cgi-bin/getrpt?GAO-05-633EUR
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