Eyes wide open: the pros and cons of deferred retirement option plans.

• Author: Dezube, Robert
• Position: Retirement planning

Over the last 20 years, Deferred Retirement Option Plans, or DROPs, have become increasingly common in the public sector. Originally conceived to retain retirement-eligible police officers and firefighters, DROPs have been offered to teachers and other public sector workers, allowing retirees in a defined benefit pension plan to receive a portion of their pension in a lump sump in exchange for additional years of service and lower pension payments over the rest of their lives. Properly designed and realistically priced by the plan actuary, DROPs can be a useful retention and succession-planning tool at a relatively low cost. But as recent high-profile cases have demonstrated, poorly designed DROPs based on unrealistic assumptions can result in significantly higher than expected pension costs and a public relations crisis stemming from large lump-sum payments to public employees. This article explains the basic features of a DROP and how to design one that is cost neutral.

THE BASICS

A DROP is similar to an optional form of benefit available through some defined benefit pension plans, but is administratively more complex. A DROP provides for the tax deferral of retirement benefits while an eligible worker continues employment, limiting access to those benefits until he or she actually terminates employment.

A traditional DROP (also known as a "forward DROP") works like this: An employee who is eligible to retire but wishes to continue in his or her current position elects to "retire" and have his or her pension calculated based on earnings and service as of the DROP election date. The employee continues to work during the DROP period, usually up to three to five years, and the pension benefits are deposited into a DROP account. When the employee officially retires, he or she receives the monthly pension benefit that was previously calculated plus the balance in the DROP account.

An example will help illustrate how this works. Pat is a firefighter who is age 50 with 25 years of service. Pat's current salary is $80,000 and he is eligible to retire with a pension of $40,000 (2 percent x salary x 25 years of service). Pat wants to continue working, and he also wants to accumulate a significant lump sum faster than he could in the deferred compensation program. The DROP offered by his employer's plan provides Pat an attractive solution. Under the DROP, Pat can continue working for up to five more years - when he will have 30 years of service--but his pension benefit is determined now (i.e., as of the date he elects the DROP). Thus, for each year of DROP participation, Pat's annual pension of $40,000 will be deposited into his DROP account. Pat will continue to earn his salary while he works, but he will not earn additional years of service for retirement benefits. If Pat continues in DROP for the full five years, he would then be required to terminate employment. He will then start to receive his $40,000 pension and will also receive the lump sum of more than $200,000 (five annual payments of $40,000, plus interest) from his DROP account.

If Pat had not elected the DROP and had retired at the later date (age 55 with 30 years of service), his pension would have been based on a higher salary and additional years of service. For example, assuming Pat's salary increased 3.5 percent per year over the five years, his salary at retirement would be $95,000 and his pension would be $57,000 (2 percent x $95,000 x 30). By electing the DROP, Pat exchanged a higher pension (based on earnings and service at the end of the DROP period) for a smaller pension plus a lump sum in the DROP account.

One variation of the traditional plan is the so-called "back DROP." In a back DROP, an employee retroactively participates in a DROP. Going back to our example, assume Pat decides to retire at age 55 with 30 years of service. Instead of choosing to receive his full pension of $57,000, he elects to have his pension calculated five years earlier and have a DROP account created "as if" he had elected a traditional DROP at that point. Pat receives a lower lifetime pension plus a lump sum. Because an employee can select between two benefit options that typically are not actuarially equivalent, implementation of a back DROP will often raise costs for the employer due to the employee's ability to select the benefit with the greater economic value.

A pension plan's liabilities will be unfavorably impacted if (I) the DROP increases the...