In a Sunday New York Times article about public pension costs, Mayor Michael Bloomberg has the following quote: “If I can give you one piece of financial advice: If somebody offers you a guaranteed 7 percent on your money for the rest of your life, you take it and just make sure the guy’s name is not Madoff.”
Bloomberg was referring to a common problem with public pension accounting: In order to claim that they have enough money to pay future retirement benefits, fund managers assume that their investments will return 7–8 percent per year. There is nothing wrong with having a target or expected rate of return, but pension benefits are guaranteed. These benefits must be paid regardless of whether the funds hit their targets.
When future benefits are guaranteed, a basic principle of financial economics teaches that actuaries must discount (reduce the value of) those future benefits at a risk-free rate, which is currently around 2–3 percent, not 7–8 percent.