Frank Knight was a legendary economics professor at the University of Chicago. He was a central figure in the development of the “Chicago School” of economics. His students included George Stigler, one of my all-time favorite U of C people, as well as Milton Friedman and James Buchanan.
In 1921, Knight wrote a book based on his PhD dissertation titled Risk, Uncertainty and Profit. This was the work leading to a term that now bears his name, “Knightian Uncertainty.” Knight distinguished decision-making in two different arenas – risk, applying to situations where probabilities are reasonably known, and uncertainty, in situations where you just don’t really know the odds.
When thinking about the future of investment returns in public pensions, which world do you think actuaries, workers, and taxpayers inhabit? A world where the probabilities are known, or unknown?
Consider the following assertions in the latest (2015) actuarial valuation report for the pension plan for Chicago firefighters.
“There is a 48.4 percent of the Fund earning an investment return of 7.25 percent or more. There is a 44.75 percent probability of the Fund earning an investment return of 7.50 percent or more.”
Put aside the failure to include the word ‘probability’ after the first ‘percent,’ and consider the breathtaking claim to knowing the odds so precisely.