Guam, the US territory about four hours' flight east of Hong Kong, is best known for its scuba diving. But it is not just Guam's tourists that are going under water: so is its $1.2 billion defined-benefit pension scheme for 16,000 government employees.

The Guam Employees Retirement Fund is expected to drop under-performing fund managers when it conducts a review this November, but that is just one part of a solution, says Gerard Cruz, a member of the fund's board of trustees as well as president and CEO at Community First Guam Federal Credit Union.

Not long ago the DB plan appeared to be in good shape. In 1997 it could meet 75% of its total liabilities, and given these stretched out 30 years, the trustees were comfortable. Today however the fund can only meet 49% of its total liabilities, which have grown to $2.3 billion.

And by law the fund must be fully funded by 2031, by which point it will have paid out the lion's share of its obligations. The fund's trustees and its actuary, Milliman, have run the numbers and worry that, at current trends, they will fall well short.

Several factors contribute to this underfunding. First, in 1995 Guam introduced a defined contribution plan that was optional for existing employees and mandatory for new ones. They closed the defined-benefit scheme to new members, but in 2000 the local legislature boosted benefits and allowed early retirement - just as equity and bond markets were tipping into a three-year bear run. In the past five years the underfunding situation has careened from acceptable to dangerous.

This is compounded by archaic statutes dating to 1951 that constrain the fund's asset allocation. Cruz believes that with more flexibility, the fund will be able to meet its obligations.

The biggest restraint is that it can directly own only stocks that have paid a dividend in three of the last five years - a wise move in the 1950s but not today, when many growth stocks in the US, and most stocks internationally, plough returns back into the business. "Closing the investment universe actually increases our risk," Cruz says.

The pension fund is also barred from asset categories such as hedge funds or real estate investment trusts, although it has a pretty free hand in fixed income, where it can go down the credit and duration curve and invest in asset-backed securities.

Cruz and other trustees are lobbying the Guam legislature to allow the fund more flexibility. But the issues are complicated and while Cruz believes the legislature will act when it realizes the potential disaster it faces - having to expand welfare to cover retirees - but it is hard to educate politicians.

In addition to fighting with one hand tied behind its back, the retirement fund faces other problems that contribute to underfunded liabilities. One is that while benefits have increased, contributions have not.

This means that meeting immediate obligations requires increasing allocations from the government's budget. Last fiscal year the government had to pay 21% on top of payroll for retiring civil servants.

This year, Cruz thinks the amount will reach 26%. He is concerned that at some point the legislature, which must approve these allocations, will not fully meet the obligation, requiring the pension fund to pay it out of its current assets and further worsen the underfunding situation.

Another reason why contributions are not keeping pace is that state-owned companies or agencies sometimes do not pay them on time. "One agency is delinquent by as much as $17 million," Cruz says. But trustees cannot do much about this, as technically they have fiduciary responsibility for the fund itself, not for potential monies. This is viewed as a labour issue but it impacts the fund's finances.

For now the fund's performance has been good. It cannot invest more than 50% into equities or fixed income, and now has about 47% invested in bonds, 37% in equities and the rest in mutual funds.

It currently uses 11 external fund management companies, with Mercer Investment Consulting as a gatekeeper. Mercer estimates that if the government pays out the extra 26% on top of payroll, then the scheme needs to make 7% to meet its immediate obligations.

For the past few years the fund has earned 9% or more, and is looking at a return of at least 8% this year. But because of all the other problems, this doesn't put a dent in the long-term underfunding.

This November, the trustees will conduct their annual review of the fund managers. In the past few years the only changes it has made have been the result of M&A.

The integration of Citigroup Asset Management into Legg Mason with its Western Asset Management bond business led Guam to drop Citi, because the trustees were not familiar with Western's process - although they would consider re-hiring Western once they got to know it. It kept Deutsche Asset Management after Aberdeen acquired the DeAM fixed income business because the trustees knew both firms and Aberdeen pledged it would not change the way the acquired DeAM business operates.

But with all the events in the past five years, such as the collapse of the tech bubble, it has been hard to tell when managers have done well or badly because of luck or skill. Now enough time has passed for the dust to settle, and Cruz says some managers may get fired for poor performance. The trustees are likely to seek out more exposure to international equities, provided it meets the current need for a dividend track record.