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In the eye of the storm

To many, the San Diego retirement plan stands as a symbol of disastrous public pension fund management. No one notices that CIO Doug McCalla has one of the best performance records in the country.

It's a warm Friday afternoon in late January, and the trustees of the San Diego City Employees' Retirement System are gathering for their monthly meeting. The bright fourth-floor boardroom is packed with dozens of worried retirees and city employees. With TV cameras whirring, the meeting erupts into a noisy melee when trustee Diann Shipione declares: "The pension fund numbers are catastrophic." She continues her peroration until, finally, the chairman cuts her off, adjourns the meeting and reconvenes the board in a closed session, from which Shipione is, pointedly, barred.

"This board has no respect for the law," she tells reporters.

Welcome to sunny San Diego, the seventh-largest city in the U.S., renowned for its handsome Spanish missionary architecture and year-round balmy weather. Once it loved to call itself "America's Finest City," but today's San Diego is as likely to be derided by headline writers as "Enron by the Sea." Small wonder. The city is choking on debt -- $1.37 billion in unfunded pension liabilities and $750 million in unfunded health care liabilities that together represent an alarming 93 percent of the city's fiscal 2005 budget of $2.29 billion.

And just about everyone is pointing the finger at everyone else. The newly elected city attorney has accused the mayor and city council members of violating federal disclosure laws; a taxpayers' association is suing the city to rescind benefits; the pension board is suing its former fiduciary counsel for malpractice. The Securities and Exchange Commission is looking into possible securities fraud in the city's financial reports, and the local U.S. Attorney's office is conducting a criminal investigation into possible public corruption by the mayor, the city council and the pension board.

At the center of the storm is the $3.6 billion-in-assets San Diego City Employees' Retirement System. The city raided the retirement plan during the 1990s bull market, hiking retiree benefits and paying for hometown goodies like subsidies to keep the San Diego Chargers football team in town. Then when markets tanked in 2000, San Diego blithely decided to increase benefits. As a result, by the most up-to-date figures (from June 30, 2004), the plan's assets stand at 66 percent of its obligations -- among the worst funding ratios in the country for all pension funds.

Making matters worse, the city failed to disclose the extent of these pension obligations when it issued municipal bonds in the fall of 2003. Standard & Poor's has suspended San Diego's rating; Moody's Investors Service and Fitch have both downgraded the city's debt, although it remains above average among U.S. municipal issues. Bankruptcy remains remote, but no one doubts that the city faces a serious fiscal crisis.

From the Connecticut River to the Cascade Mountains, the country confronts a spreading pension crisis that threatens the financial health of cities, states and corporations. Many public and private pension plans are woefully underfunded, still reeling from the double whammy of falling equity values and declining interest rates during the 2000­'02 bear market; even the Pension Guaranty Benefit Corp., the quasi­government agency that bails out bankrupt company pension plans, is strapped. But in the midst of this wreckage, San Diego's retirement system has managed to vault from utter obscurity to an unwanted iconic status as the symbol of disastrous management of public pension plans.

"San Diego has become a poster child of bad behavior," says Carl De Maio, president of the Performance Institute, a prominent government-reform think tank based in San Diego. "It's a model to city councils and county boards across the nation of what not to do."

And yet there's a strange twist to this tale: For all the bad things said about it, the San Diego pension fund itself is not the problem. Far from it, in fact. From an investment management standpoint, San Diego's plan is not only well run, it may be among the best-run plans in the country. Certainly, it stands head and shoulders above its peers in performance.

Simply put, Doug McCalla, the mild-mannered, circumspect CIO, has delivered an extraordinary performance record in his 12-year tenure. Last year the plan returned 13.7 percent, compared with 11.8 percent for the median public plan with assets of more than $1 billion, as tracked by Wilshire Associates. Over three years the San Diego fund is up an average annual 10.7 percent, versus the 7.5 percent median; over five years it gained an average annual 6.9 percent, versus the median ­3.6 percent. Looking back even further, in the ten years through 2004, the fund gained 11.2 percent a year, versus 10.4 percent for the median.

That impressive record reflects the combination of a simple, conservative asset-allocation strategy and a sophisticated rebalancing program that McCalla devised -- and subsequently wrote about in the Journal of Pension Plan Investing. His rebalancing system takes into account historical volatility patterns of the different asset classes and, unlike the approaches of most of his peers, allows for rapid response to market moves. McCalla's portfolio breakdown at the end of 2004: 39 percent U.S. equity, 17 percent international equity, 30 percent U.S. fixed income, 5 percent international fixed income and 9 percent real estate. The plan devotes 9 percent of its assets to market-neutral hedge funds, which are part of its fixed-income allocation.

Although the 55-year-old McCalla is by nature cool and unflappable, the unfolding scandal and the relentless mudslinging have taken their toll. "I've been managing an investment plan in a sea of distractions," says McCalla, a trim 6-foot-2. "People here are reputable and ethical, but our credibility has been attacked."

The CIO can't help but take some of the criticism personally. He started working for the city of San Diego 36 years ago sweeping basketball courts for $1.55 an hour. He sees public service as an honorable calling and a family tradition. His father, Howard, spent most of his career with the city's finance department; his mother, Faye, worked for San Diego County's welfare department for 20 years. "If anybody has a vested interest in how the fund does over time, it's me," he says.

So why is San Diego such a basket case? Partly it's a victim of its own success. Greedy politicians raided the kitty as it grew under McCalla's deft management in the 1990s.

As CIO, McCalla controls the fund's portfolio. But because he is not a trustee, he has had no voice in shaping important fund policies -- most critically, retiree benefits packages and the city's contribution to the retirement system -- that help to determine, or to undermine, the financial health of the pension fund.

Changes in those policies over the past nine years have brought the city and the fund to its present sorry state. With the approval of the pension fund trustees -- following votes in 1996 and 2002 -- the city cut its contribution rate to the fund and at the same time increased retiree benefits, a one-two punch that significantly weakened its ability to meet its liabilities.

In both 1996 and 2002 the trustees agreed that the city could contribute less than was actuarially required to keep the retirement system sound. Trustees were put in a bind. According to the City Charter, the 13 board members are not supposed to have a say in retiree benefits. The city decided in both 1996 and 2002 to boost retiree payments, deals that directly benefited the eight trustees who work for the city or represent its unions. San Diego's determination to underfund the system came undone last August, however, when it settled a class-action lawsuit filed by retirees against the city and the retirement system by agreeing to make its full contribution to the pension fund in future years.

Newly elected city attorney Michael Aguirre wants to throw the pension plan into receivership and roll back some retiree benefits to 1996 levels. "The only way to solve the problem is to get rid of benefits that should never have been created in the first place," he says. Last month he issued a 112-page report in which he alleges civil violations of federal securities laws by the mayor and most of the city council. He urges that the city council accept his findings and allow him to negotiate a settlement with the SEC. Mayor Dick Murphy and the pension trustees vehemently oppose Aguirre's proposal.

Aguirre has also tried to assert the city attorney's right to serve as the pension plan's legal representative, arguing that the fund's general counsel, Lorraine Chapin, should step aside. He has gone so far as to seize documents from the office of Terri Webster, a board member and the acting auditor for the city and its pension plan, and two other senior city officials. The board filed suit in superior court to block the city attorney from asserting legal authority over the pension plan and seeking the return of documents protected by attorney-client privilege. Politics, as much personal as partisan, may play a part in this showdown. Aguirre is a Democrat and Mayor Murphy is a Republican who won a contested election last fall against Donna Frye, a write-in candidate from the city council.

Aguirre has hired a well-known California litigator, Donald McGarth, to investigate legal action against the pension trustees. The majority of the 13-person board is made up of union representatives and city-appointed officials. In April, in accordance with a law passed last November, independent financial professionals will make up the majority of the pension plan's trustees.

Under the terms of last August's legal settlement, the result of the retirees' class-action lawsuit, San Diego is making its full actuarial contribution, $130 million, in the fiscal year ending this June. It will continue to do so in the years ahead.

"This," says McCalla, "is such a bizarre environment."

San Diego, McCalla was a Boy Scout and a straight shooter -- literally. At 13 he qualified as a National Rifle Association expert, a rank that required him to hit dime-size targets from four different shooting stances, at a distance of 50 feet.

After receiving a BA in industrial personnel psychology from San Diego State University in 1972, McCalla enrolled in a master's program. He got off to a good start, winning a 20-hour-a-week university-supported research job with the navy in 1973. His investigation into the way computer systems could affect organizational design and individual decision making was published in two technical reports for the navy in the mid-1970s.

McCalla planned to complete his master's and teach junior college, but he was overtaken by personal troubles. Soon after he married in 1973, his wife had to begin coping with her mother's stroke and subsequent paralysis and her brother's suicide. By 1977, McCalla had dropped out of graduate school and joined San Diego's recreation department full-time. But by then his marriage was unraveling. A year later he and his wife divorced.

McCalla remarried in 1981 and fathered two daughters, only to divorce again three years later. The couple's first child, Kristin, now 22, was born prematurely with severe Down's syndrome; today she lives with her mother, Judy, a bookkeeper, near Lake Gregory, California. Despite the divorce, McCalla continues to play an important role in her life, a factor in his decision not to pursue more lucrative work in the private sector. "I wouldn't have been able to make as effective a contribution to parenting if I were on the road working clients," he says. McCalla's second daughter, Heather, now 20 is a student of furniture design at San Diego State.

"Doug has always come through with child support and been there for the girls," says ex-wife Judy McCalla.

Looking for an intellectually challenging job, McCalla found his opportunity in 1982, when San Diego set up two retirement plans, similar to 401(k)s, for public employees. He transferred to the city's risk management department to become an administrator of the plans. "My selling points were that I had people skills, a head for numbers and a burning desire to get into the field," says McCalla, who rose through the ranks to become the revenue analyst in the city's financial management department in 1986.

It was an auspicious time. San Diego's pension fund, whose assets then totaled $493 million, was about to undergo a sea change. The following year Lawrence Grissom arrived from the Public Employees' Retirement System of Nevada to become retirement administrator, the top job at the fund. He took control of an investment program that Scudder, Stevens & Clark had been running as a balanced manager since 1962. Grissom had been on the job for just three months when Black Monday struck, hammering Scudder's investments. Then, McCalla reports, Scudder's investment strategy became so defensive that the plan didn't fully benefit from the market recovery.

As Grissom and his staff were coming to terms with the fallout from the market crash, McCalla took on a more high-profile role. In December 1988 he was elected by city employees to become one of the pension fund's board trustees. He kept his city job as a revenue analyst.

To revamp the fund, Grissom wanted to increase the number of money managers and set a more sophisticated asset allocation with the help of the fund's longtime consultant, Callan Associates. In 1989 the board, at Grissom's recommendation, issued its revised strategy, allocating 35 percent to domestic equities (30 percent large cap and 5 percent small and midcap); 55 percent to domestic fixed income, both government and corporate; and 10 percent to real estate. The board also voted to hire eight specialized money managers to replace Scudder.

What didn't change was the plan's belief in active outside managers. The San Diego pension fund has always been managed entirely from the outside. And unlike many public plans, it has steered clear of indexing. "It has been a philosophical view of the board over the years that active management outperforms," says McCalla.

With Grissom's encouragement, McCalla, as a trustee, spent much of his free time from 1989 to 1991 puzzling out a new approach to asset-class rebalancing, one that drew on his knowledge of statistics. Typically, pension plans rebalance when an asset class differs significantly from its desired weighting in a portfolio. In McCalla's scheme the timing of a rebalancing should be tied to historical volatility, with more volatile asset classes permitted bigger moves before a rebalancing is triggered. Highly volatile asset classes, such as microcaps, could lose nearly two thirds of their value -- or nearly double in size -- before a rebalancing; a low-volatility asset class, such as a fixed-income portfolio benchmarked to the Lehman Brothers aggregate bond index, might gain or lose only one seventh of its value before sparking a rebalancing. Adjusting the frequency and depth of rebalancing, McCalla argued, would enable managers to deliver more consistent risk-adjusted returns. "We want to give all asset classes equal opportunity to be sold high and bought low," he says.

One virtue of the scheme is that, unlike most pension plans, which rebalance at fixed intervals, the San Diego plan rebalances as soon as asset allocations get out of whack. McCalla estimates that rebalancing should add between 40 and 60 basis points of return a year without a commensurate increase in risk.

"In my opinion, Doug is on the cutting edge in the world of investments, with a rebalancing program that has contributed materially to the investment success of the city retirement system," says Frederick Pierce, chairman of the plan's board of trustees and a real estate developer.

But Robert Helliesen, a consultant with Seattle-based pension consulting firm Milliman USA, which has no connection to the San Diego fund, suggests that the rebalancing offers more modest benefits. "McCalla has devised a structured and carefully thought out way to rebalance," he says. "It adds a little bit of value, not a huge amount, which is what rebalancing programs do."

So far, McCalla says, only one other public plan has adopted his rebalancing approach -- the $4 billion Alameda County [California] Employees' Retirement Association. Says Alameda CIO Betty Tse, "The program has contributed to the success of our portfolio." The Alameda fund returned an annualized 9.3 percent in the three years through September 2004, compared with the median of 6.9 percent for public plans with assets greater than $1 billion, according to Wilshire.

Impressed by McCalla's rebalancing theories, Grissom named him investment analyst of the San Diego plan in September 1991. McCalla then gave up his seat on the pension fund board. He wasn't required to step down, but he believed it was the prudent thing to do.

That month, McCalla presented his rebalancing plan to the board, eventually winning over skeptical trustees. In November the board voted to implement the rebalancing program and to move money immediately from large-cap stocks into bonds and smaller stocks. McCalla's rebalancing model had been advising a reduced position in large caps since October. On the day of the vote, the market plunged 3.8 percent, one of its biggest-ever one day drops, confirming the wisdom of McCalla's scheme. "I may have achieved a little bit of guru-hood with the trustees," he says.

In 1993, Grissom promoted McCalla to chief investment officer. McCalla kept San Diego's relatively conservative asset mix intact for several years. Between 1991 and 1995 the fund returned an annualized 11.8 percent, compared with 10.5 percent for the composite benchmark.

Then in 1995 McCalla decided to move into foreign markets, the first time the plan had ever invested in stocks or bonds outside the U.S. and Canada. Global investments, generally, were still a rarity among state and city retirement plans. After winning approval from the board and the city council, which had to authorize investment in a new asset class, McCalla allocated 13 percent of assets to international stocks and 2 percent to international bonds. He also increased the U.S. equity allocation from 35 percent to 41 percent, a smart move on the eve of the late-1990s bull market. To accomplish these shifts, he slashed U.S. bonds from 55 percent to 34 percent and left the real estate allocation at 10 percent.

To handle the international equity portfolios, McCalla hired three new managers: Brandes Investment Partners for international value, Putnam Investments for international growth and Capital Guardian Trust for international small caps. In early 1998 he shifted an additional 3 percent of assets into international stocks and a further 2 percent into international bonds, taking the capital from domestic stocks and bonds.

Although he would have done better if he had stuck to U.S. equity markets, McCalla's bet on international stocks paid off. Better yet, he chose managers who far outpaced their benchmarks. For the three years ended December 31, 1998, the fund's international equity component returned an annualized 13.7 percent, far better than the 7.7 percent return for the MSCI ACWI free ex-U.S. index of international equities.

In 1999, as the equity bubble inflated and the Nasdaq soared, McCalla's rebalancing model screamed, "Sell small caps!" Beginning in September 1999 the plan trimmed small-cap stocks every other month and again in February and March of 2000, moving the money into bonds. San Diego's last shift came one week before the market peaked on March 10, 2000.

"The flexibility that Doug has is very rare within the industry," says Guy Watanabe, president of GW Capital, a Bellevue, Washington­based asset manager that handled a corporate bond portfolio for San Diego between 1993 and 1999.

McCalla's most recent major rebalancing came in February 2003 after a period when bonds had outperformed stocks. He sold $66 million in bonds and sprinkled $60 million into equities, with the remaining $6 million used to pay benefits. That April stocks began to rally while bonds began to weaken in June. By October both asset classes had again breached their target ranges, so McCalla shifted about $100 million from stocks back into bonds. The moves helped the fund return 28.2 percent in 2003, 550 basis points more than the median public plan. "Not bad for a broadly diversified portfolio," boasts McCalla.

But rebalancing explains only a small portion of McCalla's exceptional track record. Because the fund is managed by outside active money managers, performance is dependent on their skill. Clearly, McCalla, working with a deputy CIO, an accountant and an analyst, has done a consistently good job of selecting and keeping on board a group of successful stock pickers.

Fixed-income giant Pacific Investment Management Co. handles the single biggest allocation of funds, 9.8 percent of assets. Since March 1989, Pimco's fund has returned an average annual 9.84 percent, compared with 8.17 percent for the Lehman Brothers aggregate bond index. Putnam Small Cap Growth, a manager for the fund since March 1990, has returned an average annual 15.44 percent over the period, compared with 7.83 percent for the Russell 2000. Delta Asset Management of Los Angeles manages $137 million in large-cap core domestic equity. Since it was hired by San Diego in March 1995, it has returned an average annual 12.34 percent, versus 11.33 percent for the Standard & Poor's 500 index.

Like virtually all corporate and public pension funds, the San Diego plan was hit hard by the bear market of 2000­'02. Still, McCalla did better than most public pension fund managers. In 2000 his fund gained 4.6 percent, versus 0.9 percent for the Wilshire median; in 2001 it lost 1.8 percent, versus ­5.3 percent for the median; and in 2002 it declined 7.2 percent, versus a 9 percent loss for the median.

MCCALLA'S SUCCESSES AS AN INVESTOR HAVE BEEN almost completely overshadowed by the general morass that surrounds the San Diego Employees' Retirement System -- the horrendous funding ratio, the high-profile lawsuits and the federal investigations.

San Diego's troubles were caused by two fateful agreements between the city council and the pension board. The pacts were designed to give the city relief from making its full actuarial contributions to the plan between fiscal year 1997 and 2009. Worse, the city simultaneously enhanced retiree benefits. In an analysis issued last September, the City of San Diego Reform Committee found that the benefit increases agreed to in 1996 and 2002 accounted for 41 percent of the system's June 30, 2003, unfunded liability of $1.17 billion, while 10 percent was thanks to the city's underfunding of the plan and 12 percent because of the use of investment earnings for health care and other benefits. In addition, net actuarial losses accounted for 31 percent of the underfunding and investment performance for 8 percent.

In a lawsuit against the city filed in January 2005, the San Diego County Taxpayers Association, a nonprofit, nonpartisan tax watchdog group, charged that benefits were increased to win the approval of the trustees.

When the first deal was struck, in 1996, the city's demand for relief appeared reasonable to many, including McCalla. San Diego's revenues had fallen because of a local recession, while its expenses had risen because of a costly agreement to guarantee sold-out ticket sales to keep the San Diego Chargers football team in town and because of security costs to host the Republican National Convention. The well-funded pension plan was a tempting source of funds. The year before, the plan had returned 20.9 percent, and its funding level had been consistently strong -- above 90 percent -- for the previous ten years.

The underfunding deal lowered the city's pension contribution to $28 million, from $42 million, in fiscal 1997, and allowed the city to plug the budget gap. Meanwhile, hiking retirement benefits to its four unions, including police and firefighters, gave the city compensation packages that were more competitive while pushing most of the associated costs well into the future.

"The city operates in a competitive market for labor," McCalla notes. "It didn't want to be the training ground for safety officers only to have them leave and work for the county's highway patrol."

The deal between the city and the pension fund, which became effective in fiscal 1997, allowed San Diego to reduce its contribution to the retirement system, defined as a percentage of its payroll, from the actuarially required rate of 10.9 percent, the amount deemed necessary for the fiscal health of the fund, to 7.3 percent. The city promised to boost its contribution rate in each successive year after fiscal 1997 by 50 basis points until it reached its full contribution level, a target it expected to hit in fiscal 2007 at a rate of 12.18 percent.

By June 2002 the twin threat of falling equity prices and rising benefits caused the plan's funding ratio to fall to a worrisome 77.3 percent -- below the 82.3 percent floor. That meant that the city would need to make a balloon payment of some $160 million to restore the funding level as soon as June 2003.

City officials, realizing they would be hard-pressed to make the payment, first broached the issue in conversations with retirement administrator Grissom in early spring 2002. In late April the city manager, Michael Uberuaga, submitted a written proposal requesting that the funding level floor be dropped to 75 percent -- a suggestion the board rejected, reports Grissom.

The pension fund trustees granted the city a reprieve in November 2002, allowing it to continue to contribute less than actuarially required in fiscal 2003. Once again the city boosted retiree benefits. For example, instead of receiving 2.25 percent of their highest salary per year of service, general employees would receive 2.5 percent, multiplied by number of years of service. This increased the system's unfunded liabilities by $48 million in fiscal 2003.

Under the 2002 deal the city, in exchange for avoiding the balloon payment, agreed to double its annual contribution increases to 100 basis points annually beginning in fiscal 2003 and continuing through fiscal 2009. If funding again fell below 82.3 percent, the city would have to accelerate increases in its contributions. The deal also had a clear termination of June 2009.

The trustees believed that the benefits enhancements were contingent on the pension board's agreement to reduce the city's contributions to the retirement plan. The 1996 agreement did require the trustees' consent, but in closed session in 2002 the city decided to enhance benefits regardless of the pension board vote, according to the Vinson & Elkins report.

The trustees, who had no authority to determine retiree benefits, were in an awkward bind, especially the eight of the 13 trustees who either worked for the city or represented its four unions. On the one hand they -- in particular, the presidents of the city's fire, police and municipal employees unions, who were to receive special benefits -- benefited from increases in retiree packages. On the other they had an obligation to act as fiduciaries for the pension plan.

Whether the benefits were increased to win the approval of the trustees is the legal question at hand in the lawsuit brought by the taxpayers' association and in the investigation by the U.S. Attorney's office.

Only two of the 13 trustees, Diann Shipione and Tom Rhodes, a San Diego policeman, opposed the agreement.

"You could argue that we shouldn't have let the city off," says Pierce, the chairman of the pension fund board. "But we have a legal fiduciary obligation to the city as well."

Both the 1996 and 2002 pacts between the city and pension fund were deemed legal by the board's fiduciary counsel. Still, the Governmental Accounting Standards Board, which establishes standards for state and local accounting, required the city to disclose in its annual financial report and in all its bond issue prospectuses the difference between its actual pension fund contribution and what it actuarially owed to the plan. The city disclosed the existence of the new funding arrangement but failed to note that the resulting shortfall was projected to be more than $100 million over ten years.

In its January 2005 lawsuit, the San Diego County Taxpayers Association alleged that five city employees who had served on the pension fund board in 2002 had had a financial interest in voting to continue the city's underfunding in exchange for increased retirement benefits. The city is "developing its legal position," says city attorney Aguirre.

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The 2002 agreement only got the city into deeper trouble. Critically, the city's 2002 comprehensive annual financial report, a public document, failed to mention the second agreement with the pension fund board. Instead, it used boilerplate language from previous reports about the city's schedule of pension plan contributions.

The extent of the city's sloppy disclosures went largely unnoticed until early September 2003, when pension trustee Shipione, who works as an investment adviser at UBS Financial Services in La Jolla, California, realized that a prospectus for a $500 million city sewer bond issue -- whose lead underwriter was her employer, UBS -- significantly underestimated the pension plan's unfunded liabilities; she found that the prospectus was missing other important financial information as well.

Shipione sent two e-mails, one to the retirement system and one to the mayor, noting inaccuracies and omissions in the offering documents. She forwarded those e-mails to the outside legal counsel for the bond offering, San Francisco­based Orrick, Herrington & Sutcliffe. Shipione did not hear back from the law firm, but in less than 48 hours, she says, her e-mails made their way to UBS. Several days later the bond offering was postponed.

In January 2004 the city made the first of three voluntary disclosures about its pension liabilities. A month later federal and local investigations began, and the city by the sea descended into the maelstrom of recrimination, back-stabbing and lawsuits that has stunned local residents. "I've never seen the climate like this before in the city," says Chapin, the retirement system's general counsel. "There are a lot of hidden agendas out there, and our retirees are being frightened."

Through it all Shipione has stayed on the offensive (see box). In a tireless series of attacks, she has accused board members of approving the underfunding mainly to boost their own benefits and of underestimating by billions of dollars the plan's unfunded liabilities. In January the board alleged she had given privileged information to an attorney, Michael Conger, who has sued the pension plan's former fiduciary counsel, Robert Blum of Hanson, Bridgett, Marcus, Vlahos & Rudy of San Francisco, for malpractice in approving the 2002 underfunding deal. The pension system, which has legal standing in the case, also sued the former counsel and has reached a conditional settlement in which the law firm will pay a purported $15 million without admitting fault. Conger's legal fees are at issue.

Says board chairman Pierce: "Diann Shipione breached our confidentiality by virtue of disclosing confidential attorney-client privileged information to the plaintiffs in a multimillion-dollar lawsuit against us. We have definitive evidence of that in the form of a declaration submitted by the plaintiffs to the court." Shipione calls the charges "trumped up."

McCalla is at pains to distance himself from the city's fiscal crisis, noting that he wasn't on the board when it agreed to let the city lower its contributions and that it isn't his role to set policy, only to implement it. "As investment officer, I choose to be no smarter than the 13 trustees," he says. "I'm like Scotty down in the engine room," he jokes, referring to the Star Trek engineer who was always struggling with the engines of the Starship Enterprise when calamity struck. "Captain, I've squeezed everything out of the dilithium crystals."

Nonetheless, McCalla is loath to criticize the agreements. "Everything can be judged in hindsight," he says. "In 1996 there wasn't any scenario that saw the greatest downturn in the market since the Great Depression. But knowing what we know now, things might have been done better."

San Diego has started to grapple with its problems, although a tough battle lies ahead. Mayor Murphy and the city council have begun their annual labor negotiations with a harsh proposal that includes a two-year salary freeze for city employees, increased worker pension contributions and reduced benefits, moves that would reduce the plan's $1.37 billion unfunded liability by some $600 million over the next two years and shave $40 million off the city's budget next year.

The mayor has also called for the issuance of $600 million in pension obligation bonds to help close the funding gap. That option remains out of reach until the city completes its audits for fiscal 2003 and 2004.

San Diego has admitted that it inadequately disclosed its pension liabilities in various financial reports and bond offerings. In September, Houston-based law firm Vinson & Elkins, hired by the city in February 2004, issued a scathing report on San Diego's finances, noting that since 1996 its financial reports have been riddled with inaccuracies and omissions that obscured the growing pension liabilities. The law firm is defending San Diego in the SEC investigation.

The city cannot return to the bond market until it completes audits for fiscal 2003 and 2004, which end in June. San Diego has hired KPMG and Macias, Gini & Co. to independently audit its financial statements for 2003 and 2004, respectively. In October, KPMG said it could not do so until City Hall had investigated "likely illegal acts."

"We believe the city has the financial ability to stem its growth in pension costs," says Amy Doppelt, a public finance analyst at Fitch. "But there needs to be strong action to limit pension benefits, shift spending from other programs or find new revenues."

Beginning this fiscal year the city will be making its full actuarial contribution, $130 million, and will contribute a projected $155 million next year. But even without the infusion, the pension system's funding ratio would likely improve over the next couple of years. Like all pension plans the actuarial value of the San Diego plan's assets reflects a smoothing process that takes into account the investment performance over a five-year stretch; the beginning of the 2000­'02 bear market will soon start to drop out of the calculations, meaning the plan's financials will improve.

McCalla hopes to stick around until January 2010, when he has agreed to step down as part of a deferred retirement program that he entered in January. But forces beyond his control could accelerate that move. As a result of a proposition that city voters approved in November, a new pension board will be constituted in April, one that will be dominated by independent directors; trustees will have four- instead of six-year terms. And Grissom, McCalla's staunch supporter, is 62; he could retire in a couple of years.

Characteristically, McCalla remains unfazed by the uncertainty. But he is proud of what he has accomplished, and he wants his excellent work to be acknowledged.

"Inside the fund and among the board members, there has been sufficient recognition and appreciation of our investment program that more than offset any of the negative comments," McCalla says. "But in the absence of that, it might be a little hard to hang around here."