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There is an uncivil war raging in the United States. It’s between government employees and taxpayers who fear that those employees’ generous pensions will lead to inexorably higher taxes and more slashes in services. This war is particularly hot in jurisdictions such as the City of San Diego, in which it is clear that the government cannot pay what it owes the pension fund in future years.

Intensifying this war is the fear of deflation, or an extended period of falling prices and wages, last seen in the Great Depression of the 1930s. Some prominent economists who predicted the current mess, such as New Jersey’s A. Gary Shilling, think deflation is coming. The economy of the past three decades was pumped up by debt. Now individuals and institutions are trying to shave those debts. There is at least a 25 percent chance that a deflationary skein could result, says North County financial advisor E. James Welsh.

In a deflation, people on fixed incomes, such as those receiving pensions, are the winners: their money rises in value when prices recede. But the governments paying those pensions suffer: as prices and incomes drop, so do tax receipts. That makes it even harder to make those pension payments.

All this has created a second war. It’s between those who foresee deflation and those who are more fearful of inflation, or rising prices. Actually, we could get hit with inflation because of the government’s frantic efforts to prevent deflation.

If a pension fund believes deflation is coming, it should load its portfolio with high quality bonds, such as U.S. Treasury paper, and cashlike instruments, which gain value in deflation. Quality bonds and cash did very well during the Great Depression, while stocks did poorly.

But to fight deflation, the federal government has rolled up massive deficits while the central bank, the Federal Reserve, has created money at a breathtaking pace. If the economy actually does turn upward significantly, inflation and interest rates will go up, the bonds (which move inversely with interest rates) will crash, the portfolios wither, and seething taxpayers will have to pick up the tab. Those foreseeing deflation will lose their war — and their shirts.

In an inflation, those receiving pensions will lose: the value of the money they receive will go down, not up as it would in deflation, even though they may get a cost-of-living adjustment.

The Federal Reserve wants to see mild inflation — the best of all possible worlds. But pulling that off requires heroic dexterity. Stocks would do well and bonds would do moderately poorly in mild inflation. If inflation zooms as it did in the 1970s — and that’s likely considering how much money has been created — bonds would certainly go in the tank, and stocks would probably join them.

Most pension funds today are still loaded with stocks, not bonds, as if mild inflation will win out.

The City and County are going in different directions. San Diego City Employees’ Retirement System has almost 60 percent of its portfolio in stocks and only about 25 percent in bonds. “Our board is thinking about deflation…we have a new investment consulting firm looking at where the economy is,” says chief of staff Rebecca Wilson, but the system sticks with its stock-heavy portfolio.

By contrast, U.S. Treasury bonds of various maturities are the single biggest holding in the portfolio of the San Diego County Employees Retirement Association. Conservative, stable value assets are a much larger piece of the pie than gamier investments. Says chief executive Brian White, “We’re definitely concerned about [deflation] and looking for downside protection. We have added Treasury bills to the mix. They are closer to cash.”

Both funds carry an assumed rate of return that Mike Stolper, San Diego investment advisor, calls “delusional, an exercise in fantasy.” The City’s is 7.75 percent a year, and the County’s is going from 8.25 percent to 8 percent next year. Both funds have lost money over the past three years and made far less than their assumed rate of return the past five.

I asked San Diego financial advisors what they are telling pension plans to do. “There is a significant possibility of global deflation,” says Stolper, noting that there is “excess capacity and massive debt liquidation” — two of the classic signs. Pension funds “have two entirely different strategies [stocks versus bonds] that are arguably polar opposites,” says Stolper. “Funds could get genuinely whipsawed.” While bonds have done better in the past ten years, stocks have outperformed over many decades, says Stolper. So he would still have more stocks in a portfolio. “There will be a reversion to the mean, but I may be wrong for another ten years.”

Solana Beach advisor Neil Hokanson says, “Countries tend to inflate their way out of debt problems.” That’s what the United States will likely do. “Equities [stocks] look more attractive to us than bonds, particularly since dividend yields of stocks are higher than the yields on bonds.” But if deflation can’t be thwarted, he would buy 30-year Treasury bonds.

Also preferring stocks is Mike Munson, portfolio manager of San Diego’s Denali Advisors. “I would still have 55 to 60 percent of the portfolio in high-quality stocks just because I think the Fed will keep rates low enough to prevent deflation. We might have deflation in the short run, but it’s highly unlikely we would have it in the long run.”

Stocks used to make up 60 to 70 percent of the balanced, conservative accounts at San Diego’s Messner & Smith money management firm. “Now we would have between 45 and 50 percent in equities and the rest in fixed income [bonds] and cash [short-term instruments paying interest]. Things are so negative now that we don’t want to kill everybody,” says John Messner, whose primary concern is the risk of another economic downturn.

Pension funds have a particular problem, says Messner, quoting a New York Times story. In 1950, life expectancy was just short of 69 and the average retirement age was 67. Now the average life span is 78 and the average retirement age has dropped to 62. Funds make payments for many more years.

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SurfPuppy619 Aug. 25, 2010 @ 3:29 p.m.

Both funds carry an assumed rate of return that Mike Stolper, San Diego investment advisor, calls “delusional, an exercise in fantasy.” The City’s is 7.75 percent a year, and the County’s is going from 8.25 percent to 8 percent next year.

In May 2008, Federal Reserve Vice Chairman Donald Kohn delivered important remarks on this obscure but consequential issue of ROI:

"Public pension benefits are essentially bulletproof promises to pay.

The only appropriate way to calculate the present value of a very-low-risk liability is to use a very-low-risk discount rate. However, most public pension funds calculate the present value of their liabilities using the projected rate of return on the portfolio of assets as the discount rate. This practice makes little sense from an economic perspective [and] pushes the burden of financing today's pension benefits onto future taxpayers, who will be called upon to fund the true cost of existing pension promises."

These idiots running gov pension funds tha are loading up on stocks, or even worse jumping in bed with hedge funds, need to be tarred and feathered and run out of town on pitch forks.....

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Don Bauder Aug. 25, 2010 @ 4:56 p.m.

Response to post #1: Stolper is right. This is not an 8% world. But if the pension funds were honest, then municipalities, particularly San Diego, would REALLY be broke, because they would have to put even more money in the pot. Even accepting SDCERS' delusional expected rate of return, San Diego cannot possibly pay what it owes the pension fund. Best, Don Bauder

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shardjono Aug. 25, 2010 @ 8:07 p.m.

When the targeting return was established in the high rate, then the pension fund manger tends to be greedy and will not so rational in making investment decisions. It will end up with suffering in achieving the target and brings the pension fund in to the unfunded position. In this situation, paying the liability in the future will be a problem. I agree that applying a low-risk discount rate is the rational way in investing of pension fund.

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Don Bauder Aug. 25, 2010 @ 8:13 p.m.

Response to post #3: Yes, setting up a grossly unreal target rates of return invites gambling. Look at the pension funds (including SDCERS and SDCERA) that have gone into exotic and dangerous areas which they had no business getting into: private equity groups, hedge funds, quants, venture capital, etc. Best, Don Bauder

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JustWondering Aug. 26, 2010 @ 12:42 p.m.

Two issues.

First the COLA. SDMC §24.1505(a) details the rules of the COLA and how it is applied. This includes the possibility of a DECREASE not increase based up Bureau of Labor Statistics Consumer Price Index. Here is the link to the SD Muni code: http://docs.sandiego.gov/municode/MuniCodeChapter02/Ch02Art04Division15.pdf

While a decrease has not happened to date, it can and Ordinance codifies it. If we fall into a deflationary period, we can expect SDCERS pensions to decrease too.

Second issue.

Assumed rate of return. While the rate seem high in the context of today's economic climate, the facts are SDCERS has met or exceeded the rate regularly. This year the return was 13.1%, 5.35% higher that the expected return.

And yes, before SP jumps all over me, there have been years when the rate was not met. Nevertheless, there have been other years when the expected rate of return was 8% but the system earned 18-20%, more than doubling the expectation.

Additionally, under SDCERS Board rules, the Board of Trustees reviews the rate annually. Then, based upon information supplied by actuarial professionals, and experience studies sets an appropriate rate. My point is the rate is not just picked out of the air or pegged by throwing a dart.

The lowering the rate to what might be the perceived 2010 economic reality will produce a negative effect on city budget. It will force the actuary to INCREASE the City ARC or Actuarially Required Contribution thus further eroding the City's general fund.

Long Term is the key. In fact, when we examine the S&P 500 index between 1/1/1940 and 12/31/2009 the average rate of return, adjusted for inflation, is 8.20%

Sounds like the investment professionals have it just about right to me.

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Don Bauder Aug. 26, 2010 @ 12:59 p.m.

Response to post #5: Since stocks are a little over 50% of the portfolio, the S&P 500 is not a good measure. I agree with Stolper that the current expected rates for both SDCERS and SDCERA are delusional. Warren Buffett agrees, too. This is not an 8% world, and hasn't been for this decade. Yes, if the assumed rate were lowered, the City and County would have to throw more into the pots. Best, Don Bauder

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JustWondering Aug. 26, 2010 @ 7:19 p.m.

What indices would you use to rate performance of a "small" public pension system?

You say Warren says it's not an 8% world, but in what context? Short term, longer? Please explain how SDCERS manages to earn eight or more percent if its not?

I'd say if we had all not suffered the worldwide economic collapse, brought on by Wall Street greed, and the repercussions over the last few years, we may not be having this conversation. Even as bad as it's been, for the fiscal year ending in June 2010, SDCERS earned 13.1 on its portfolio.

I believe SDCERS funding ratio is now about 66%. While ABSOLUTELY nothing to brag about, it is moving in the right direction.

Combine this with pension reforms in place since 2005 and we find headway being made over the City's premeditated and deliberate underfunding.

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Founder Aug. 26, 2010 @ 9 p.m.

Reply #8 Hey JW "if we had all not suffered the worldwide economic collapse, brought on by Wall Street greed, and the repercussions over the last few years, we may not be having this conversation."

BUTT IT DID...

So we are having this conversation!

Our Leaders have given away "Our Farm" in return for getting election/support and BTW:their own Salary and future pensions... This realization will eclipse all the "pie in the sky" and "Mooning" over our "First Responders/HERO's" that have feathered their beds using huge amounts of Public dollars because they and our Leaders made sure that they would be all gifted with plenty of public money both now and in the future...

$cary for US and VERY Profitable for all of them...

What's wrong with that picture?

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Don Bauder Aug. 26, 2010 @ 9:04 p.m.

Responses to post #7: 1. Buffett said he would put it at about 5 or 6% several years ago; 2. SDCERS's ten-year return is merely 4.5%, a bit over half the assumed rate of return; 3. A 66% funded ratio is awful; 4. And 13.1% for the year ended mid-2010 is not all that good. The average return has been a negative 4.5% over a three-year period, and plus 2.7% over a five-year period. Stocks moved up more than 60% in the rebound that began in March of 2009. Bonds were strong in that period. SDCERS should have done better than 13.1% coming out of that deep ravine. Best, Don Bauder

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Don Bauder Aug. 26, 2010 @ 9:08 p.m.

Response to post #8: Yes, Wall Street almost led us over the cliff and was still able to dodge significant reforms because of the clout it has in Congress. Moreover, the economy is weakening noticeably again and financial assets may well do the same. Few planned for this. Things shouldn't be this way. But pension funds have to deal with the way things are, rather than the way things should be. Best, Don Bauder

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SurfPuppy619 Aug. 26, 2010 @ 9:09 p.m.

My point is the rate is not just picked out of the air or pegged by throwing a dart.

It doesn't mater how they are "picking" the rate-throwing darts or otherwise-the assumed rate of return is too high.

ALL the experts say that anything above 6% is too high-6% may be yoo high-the only ones who don't say that are the pension systems themselves, and we know how accurate they have been in the past.

See Fed Reserve Kohn's comment in post #1.

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SurfPuppy619 Aug. 26, 2010 @ 9:12 p.m.

The lowering the rate to what might be the perceived 2010 economic reality will produce a negative effect on city budget. It will force the actuary to INCREASE the City ARC or Actuarially Required Contribution thus further eroding the City's general fund.

And yet another reason to BK the pension system b/c they are NOT sustainable using a realistic discounted rate.

You cannot fund a 3%@50 pension with 5% returns over 30 years unless you're contributing twice the amount of the salary into the fund. So unelss we want to boost the pension fund contributions to 5 times the city budget they have to be adjusted-to a far later age and a lower pension.

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SurfPuppy619 Aug. 26, 2010 @ 9:15 p.m.

Long Term is the key. In fact, when we examine the S&P 500 index between 1/1/1940 and 12/31/2009 the average rate of return, adjusted for inflation, is 8.20%

DJIA 5-13-1999 = 11,100 (when SB 400-3%@50- was passed) DJIA 8-26-2010 = 9,9864

A full 1,114 point LOSS over 11 years

So, where is the ROI???????????????????????????

No 8% there-not even 1/10 of 1%

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Don Bauder Aug. 26, 2010 @ 9:19 p.m.

Response to post #11: But if there is a reasonable assumed rate of return, then cities would be even more insolvent than they are now. There are political obstacles to the truth. 'Twas ever thus. Best, Don Bauder

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Don Bauder Aug. 26, 2010 @ 9:23 p.m.

Response to post #13: The Dow and S&P 500 both moved up inordinately strongly for several decades. We are just reverting to the mean. The government did everything in its power to run stocks up after 1980 and it was successful. But those efforts have now run out of steam. We're in a secular bear market for stocks that could last even longer than another 5 years. (Usually these secular bull and bear markets last around 16 years.) Best, Don Bauder

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Burwell Aug. 26, 2010 @ 9:23 p.m.

In fact, when we examine the S&P 500 index between 1/1/1940 and 12/31/2009 the average rate of return, adjusted for inflation, is 8.20%

The United States was at the peak of its economic power during the period 1940 through 1970. For example, in 1968 U.S. factories manufactured 585 million pairs of shoes and 6 million bicycles. We will never see this level of economic output and growth again. As the Germans say, the U.S. is kaput. The S&P will never grow at 8.2% again.

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SurfPuppy619 Aug. 27, 2010 @ midnight

The United States was at the peak of its economic power during the period 1940 through 1970. For example, in 1968 U.S. factories manufactured 585 million pairs of shoes and 6 million bicycles.

Wow-that pretty much says it all, and why we are really a nation in decline-through bad leadership INO. Leaders that alllowed entire industries to be hijacked and taken over by foriegn countries (TV's, by way of example, were once 100% manufactured in this country-until Japan hijacked it through unfair trade practices, and our leaders did nothing to stop it, Japan also hijacked our steek insductry by "dumping" hteir steel until our steel mills folded).

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Don Bauder Aug. 27, 2010 @ 7:20 a.m.

Response to post #16: I wouldn't use the term "never." The economy and stock market don't necessarily run parallel these days. If a flood of liquidity brought back mild inflation that could be kept mild -- pretty hard to do -- equities could enjoy a stiff rally as bonds fell. And there will be another secular bull market in stocks at some point. For the next few years, the economic outlook looks pretty lame. But stocks could rise in such an environment if they were buoyed by liquidity. Best, Don Bauder

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Don Bauder Aug. 27, 2010 @ 7:25 a.m.

Response to post #17: I wouldn't necessarily put the blame on foreign countries and their unfair trade practices, although they are factors (China being the example now.) U.S. companies shipped their manufacturing operations overseas to jack up their short term profits and justify outrageous top executive pay. American greed gave our manufacturing base away. Best, Don Bauder

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Founder Aug. 27, 2010 @ 8:32 a.m.

Reply#19 Greed is "THE" biggest American industry now...

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Don Bauder Aug. 27, 2010 @ 9:29 a.m.

Response to post #21: And greed is being taught at U.S. business schools. Best, Don Bauder

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Twister Aug. 31, 2010 @ 10:51 p.m.

I'm going to try to post this link again. For some reason the whole thing didn't print in the previous message.

What do y'all think of this? http://blogs.ft.com/economistsforum/2010/08/the-fed-should-raise-rates-and-lower-them-too/

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Don Bauder Sept. 1, 2010 @ 7:06 a.m.

Response to posts #22 and 23: Very interesting article. I think the Fed will at some point be forced to buy paper issued by states. Raising the fed funds rate is an interesting concept: the writer says it will boost consumer savings. But since when does the Fed worry about consumers more than it worries about banks, which run the Fed? Wall Street loves getting money at near-zero percent with the possibility of gambling with it any way it wants. The Fed won't take that away from the banks. Best, Don Bauder

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SurfPuppy619 Sept. 1, 2010 @ 8 a.m.

17 is RIGHT ON! But 19 also is correct. What's INO?

Sorry, me and my typos, I meant IMO-in my opinion.

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Don Bauder Sept. 1, 2010 @ 3:07 p.m.

Response to post #25: Even I knew that you meant IMO, and I know what it means! Best, Don Bauder

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Twister Sept. 1, 2010 @ 3:56 p.m.

I suspect the only choice is for us humans to cooperate with each other directly, eschewing anything advertised (it HAS to be a lie), and opting out as completely as possible. Then the plutocrats could sell yachts to each other until they reach plutonomy nirvana.

What if they gave a bash and nobody cleaned the toilets? Learn to eat bugs and don't be a slave/goon. Mutual assistance.

BTW, I dnt txt.

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a2zresource Sept. 1, 2010 @ 4:36 p.m.

RE "I suspect the only choice is for us humans to cooperate with each other directly, eschewing anything advertised (it HAS to be a lie), and opting out as completely as possible. Then the plutocrats could sell yachts to each other until they reach plutonomy nirvana":

We practice this a lot in my neighborhood (and across the county with relatives & friends), doing things for each other without concern as to cost, knowing that each of us is part of a network that won't let us all go homeless. There's a lot of fresh fruit exchanged for baked goods, tree trimming for firewood, auto repair "internships" and all kinds of other zero-value, untaxed "commerce" going on in the local underground market.

This allows me to keep my ethics: if the County does not inspect and approve fruit coming out of my yard, then I can't sell it, but I can gift it to my neighbor when I see her at the fence. Likewise, the health inspectors don't check out my neighbor's pies to approve them for sale, so she just sends them over for free. Later when I have enough solar panels, I'll just start giving away electricity to my neighbors because the Federal Energy Regulatory Commission isn't going to hear from me about becoming a Qualifying Facility so I can actually sell it... and I'd feel funny about taking money from my neighbors who aren't rich for something I'd be getting for free from the Sun anyways.

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Don Bauder Sept. 1, 2010 @ 9:36 p.m.

Response to post #27: Under such a system, the plutocrats would soon fold. But so would the rest of us. Best, Don Bauder

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Don Bauder Sept. 1, 2010 @ 9:38 p.m.

Response to post #28: Some day you may be a typist, but you will never be a typists. Best, Don Bauder

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Don Bauder Sept. 1, 2010 @ 9:40 p.m.

Response to post #29: Sounds like you folks have a quasi-kibbutz. Best, Don Bauder

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Founder Sept. 4, 2010 @ 7:50 a.m.

Reply#29 It's what use to be called bring "Neighborly", you lookout for and assist your neighbors and they hopefully would do the same for you. By working together, you enable each other to be better than each of you would be alone.

If more folks followed the Golden Rule, instead of just seeking Gold, we would not be in the situation we are in now!

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Don Bauder Sept. 4, 2010 @ 2:55 p.m.

Response to post #33: But, as they say in Yiddish, suppose your neighbor is a gonif (a crook). Or a yentzer (a philanderer AND a crook). Then what? Can you trust your neighbors? Best, Don Bauder

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Founder Sept. 4, 2010 @ 7:29 p.m.

Reply # 34 And I'm only guessing here, that once your local Community found out about it, they would then decide what course of action to take to solve their own problem!

As folks decided to relinquish their personal input into these issues; local Government was only too happy to step in and take control and levy taxes!

If these same Leaders became the very folks that they were hired to protect the citizens from, then folks either moved, knuckled under or sought someone to act to protect them (Think Godfather Saga) which also had it's own price!

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Don Bauder Sept. 4, 2010 @ 8:26 p.m.

Response to post #35: When people vote with their feet, it's meaningful. Best, Don Bauder

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Founder Sept. 5, 2010 @ 7:13 a.m.

Reply #36 I guess that is why the 60's scared Big Business so much!

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Don Bauder Sept. 5, 2010 @ 7:56 a.m.

Response to post #37: It's possible that the period 2010-2020 will prove even scarier. Certainly, 2007-2010 was frightening enough. Best, Don Bauder

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Founder Sept. 5, 2010 @ 10:38 a.m.

Reply #38 I believe that in the future, the "Teens" (2010-2020) will be known as the Decade of GREED...

Where the Wealthy realize control over everything except global pollution (aka "eco-terrorism") by the World's poor...

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Don Bauder Sept. 5, 2010 @ 6:48 p.m.

Response to post #39: Hey, we've had three decades of unrestrained greed: the 1980s, 1990s, and the 2000s. And I agree with you: there are no signs it will let up. Best, Don Bauder

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