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Great Expectations. Charles Dickens wrote the classic. San Diego, going to the dickens financially, could write a sequel, Inflated Expectations.

The city got into its pension amess because, among many unwise things, it had the expectation that the stock- market boom of the late 1990s would continue. It also had the expectation that the citizenry -- and buyers of city bonds -- would never know the books were cooked to cover up the deliberate underfunding of the pension program.

The city isn't chastened. It still expects that, long-term, it can make 8 percent a year on its investment portfolio. (The county expects to make 8.25 percent annually.) Realists say the expectation should be 4.5 to 6.5 percent. But if the expected return were lowered, then the city and its employees would have to put even more into the pot each year, and government services would be slashed even further. Alas, realism has few political allies.

But this is no time for self-delusion. Federal investigators are probing into how the city hid its massive pension deficit from bond investors. To balance budgets bloated by corporate welfare, the city for years made inadequate contributions to the pension fund. To do so, it had to get permission from the San Diego City Employees' Retirement System board, made up primarily of city employees and their union representatives. The board approved the underfunding, as long as benefits would be boosted sharply. Now the city must put $200 million a year into the pot until 2011 just to remain at 67 percent funded.

Last week, Mayor Dick Murphy proposed that the city help fix the problem by selling at least $200 million of pension obligation bonds and by changing the composition of the pension board so that outsiders would have a slight majority over employees and their union leaders.

But Murphy does not propose to lower the retirement benefits now promised to retirees. Nor does he address in any way the corporate welfare that led to the plundering of the pension fund. Piling on debt and dodging basic reforms "just hands the problem to whoever takes the mayor's job in 2008," says Diann Shipione, the whistle-blowing pension-board member who brought the cancer to the public's attention. "The reality is there isn't a solution. The city has overpromised." Bankruptcy may be the only option, she says.

One of the best reforms would be to stop overestimating future investment returns. The city's actuary, Rick Roeder, estimates that if the assumed yearly return dropped to 7.5 percent from 8 percent, the city's deficit would grow from the current $1.16 billion to $1.38 billion, and the funded ratio would decline from 67.2 percent to 63.2 percent.

Roeder suggests that the projected return be dropped to 7.75 percent. I interviewed three members of the pension-reform committee. Timothy Considine believes that 8 percent is realistic. Robert Butterfield goes along with an initial 7.75 percent, but "we need to go with that figure for a year or two and adjust downward again if we have to," he says. However, William Sheffler is more conservative. "Realistically, expectations should not be all that high," he says, even though most cities go with 8 percent.

There are compelling reasons for pension funds to be conservative. Stocks and bonds thrive in an atmosphere of lower interest rates. In the early 1980s, interest rates zoomed to around 20 percent and steadily descended. For almost two decades to 2000, stocks returned an average 18 percent a year, twice the normal rate. Bonds went up by 10 percent a year, more than double the usual rate. In 2000, stocks plunged into the second-worst bear market since the Great Depression. Because the Federal Reserve was bringing down interest rates to fight recession, bonds continued to thrive. (Bond prices and their yields, or interest rates, move in opposite directions, like two buckets in a well.) But bond prices peaked out a year ago, when the interest rate on the ten-year treasury note dropped to a low of 3.11 percent. Then, as bond prices plunged, that yield soared to 4.87 percent last month. But in the past three weeks, as the economy softened, the yield dropped below 4.5 percent, and bond prices recovered. Still, most analysts believe bonds will not do well over the next several years.

Stocks look limp, too. During their three-year bear market, stocks never got historically cheap. Their dividends remained low, and their prices, as a multiple of their earnings, remained comparatively high. Stocks rose 25 percent last year but have been flat this year. Since stocks normally rise in an election year and also during the initial stage of a transition to higher interest rates, the market's stickiness is a cause for concern. Bottom line: both stocks and bonds are overpriced.

Two years ago, John C. Bogle, founder of Vanguard mutual funds, said that with both bonds and stocks having little room to move upward, pension funds in the future should count on just 4.5 percent a year. Omaha's legendary Warren Buffett puts it at 6.5 percent.

Top San Diego market pros agree. Neil C. Hokanson of Hokanson Capital Management in Solana Beach, counsels many pension funds. "We usually tell clients to expect 5.5 to 6 percent a year," he says. Over the long period, stocks won't do as well as they have in the past. "Earnings growth will be slower in the future," he says, because too many discretionary dollars are going to consumer, corporate, and government debt. Also, "The U.S. is no longer the only kid on the block."

James Welsh of Carlsbad's Welsh Money Management says it will be tough for pension plans to make 5 to 7 percent annually. History shows that big stock runups are followed by "12 to 15 years when the stock market goes sideways or completely falls apart," he says. He believes that four years ago, stocks began a 10- to 15-year bear market.

"Anybody who buys a bond for investment today is crazy," says retired money manager Dennis Muckermann, who expects high inflation and interest rates. And "stock prices remain high, dividends remain low, and corporate accounting abuses have not been corrected."

Then there's Robert Snigaroff, the county's former chief investment officer. On October 5, 2000, he told his board that the stock market might be a bubble, and the percentage allocated to stocks should drop from 70 to 60 or 50 percent. He was voted down. Now, as head of Denali Advisors, he has the county as a client. All he'll say is that he is conservative, "and the current board is working conscientiously."

Doug McCalla, chief investment officer for the city's system, says the fund made 8.35 percent a year for the past five years and 10.63 percent for the past ten. It's consistently ranked among the better performers and is now in the top 1 percent, he says.

But both Shipione and Jim Gleason, a 12-year pension board member, challenge the touted numbers, particularly since the fund is 53 percent in stocks, 37 in fixed instruments (mainly bonds), and 10 in real estate. "I have never been able to fathom how they come up with that 8 percent or more, and I haven't thought others on the board understood it either," says Gleason, suspecting "funny accounting."

"Something doesn't add up," says Shipione. The city says its deficit is a result of stock-market losses, "then we hear we're doing great in the stock market." It cries out for a comprehensive audit, she says.

Mercer Investment Consulting suggests that San Diego could use one of two figures: 6.95 percent a year by one method and 7.02 by a second. But in the second case, Mercer says San Diego could add almost a full percentage point because it selects professional money managers. However, studies show that 60 to 90 percent of money managers consistently underperform the market. In my opinion, if anything, something should be subtracted. Mercer won't comment. "Some people are better at picking managers than others," says McCalla, who also says he has built "a better mousetrap" that permits him to move money from one sector to another quickly. But that's challengeable, because he can only boost the equity portion, for example, from 53 percent to 56 percent, and making such allocation switches is a tough game.

Overall, for any pension plan like the city's, an expected return "north of 7 percent is not defensible," says Hokanson.

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