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To DROP or not to DROP? (1999)

To DROP or not to DROP, that is the question . . . that will face an increasing number of AFSCME members. Deferred Retirement Option Plans (commonly called DROP plans or DROPs) are a hot topic on the state and municipal pension scene. DROP plans are being legislated or negotiated in ever-increasing numbers.

A DROP plan is a pension provision that allows an employee who is eligible to receive normal retirement benefits to begin payment of those monthly benefits while continuing to work for a period of years. Payments are usually deposited into an interest bearing account, and the total accumulated value of this account is paid in one lump sum to the employee upon actual retirement.

The first DROP plan was adopted in 1982. Growth was slow during the early years, but the strong economy over the past 5 years coupled with the aging of the workforce has created a shortage of skilled workers. The current shortage of qualified teachers is just one example of this problem. DROP plans offer a strong financial incentive for public employees to postpone their retirement and, therefore, are being adopted at a rapid pace in order to retain trained and experienced employees.

The early growth of DROP plans was in pension systems covering teachers, police officers and firefighters. However, DROP plans for corrections officers and general employees are becoming more frequent due to a shrinking pool of skilled employees in these and other occupations.

Florida and Texas now offer DROPs to general employees, and CalPERS (the California system covering state, county and municipal employees) is considering it. Many municipal governments have also adopted or are considering a DROP plan.

Advantages

DROPs can be an attractive option for members who have "maxed out" under their pension plan's benefit formula, or for members who do not anticipate a promotion or other special salary increase. DROPs also work well for those who need a lump sum to pay off their home mortgage or other one-time cost at retirement, and for those who can live comfortably on the monthly benefit amount that is already accrued at the time of the DROP. Take-home pay may also go up at the time of the DROP since employee contributions stop when benefit payments begin.

Members who are single and whose children, if any, are too old to qualify as "survivors" will forfeit their pension benefits if they die before retirement. Choosing a DROP would allow these members to retire with a survivorship option for their companions, adult children or other friends or relatives while continuing to work. Similarly, members (or their dependents) with medical conditions that require expensive treatments and who do not have access to employer-provided retiree medical insurance can choose to lock in their pension benefit using the DROP while continuing to work until eligible for Medicare coverage at age 65.

Disadvantages

The most obvious disadvantage is that no additional pension credit is earned once the DROP becomes effective. Therefore, salary increases after the DROP date will not become part of the "final average compensation" and any improvements made to the pension plan are forfeited. Another disadvantage is that the employee must actually leave employment at the end of the DROP period. In other words, the decision is irrevocable once the first DROP payment is made.

Another possible disadvantage is that the interest rate paid on the accumulation account may be too low. Similarly, it is possible that the accumulation account may suffer investment losses during the DROP period.

Consider This

There are many issues to consider in structuring a DROP. Among them are:

Tax Implications

The monthly payments into the accumulation account, plus investment earnings, are tax-deferred as long as the pension plan maintains its tax-qualified status. Members should consult with their own qualified tax advisor prior to recovering the lump sum portion upon retirement.

DROP Period

A typical DROP allows the employee to extend employment for up to 5 years. Some plans also include a minimum period, such as 2 years, in order to make the length of the postponed retirement meaningful.

Once the minimum period is reached, most plans allow the employee to leave employment at any time during the remainder of the period. However, some plans may require that the employee stay until the date initially chosen by the employee. In other words, a typical plan might require at least 2 but no more than 5 years of employment, but a DROP plan could require a fixed number of years without flexibility.

Accumulation Account

Most plans pay the monthly annuity into an account that is credited with a fixed rate of interest. However, some DROP plans allow the employee to "self-direct" the account in a manner similar to 401(k), 403(b) and 457 deferred compensation accounts. While the advantages of this seem obvious, it presents the risk of suffering investment losses. This can be mitigated if the available investment options are fairly conservative or the plan requires a sizable portion of each payment to be made to a "guaranteed interest" account.

Back DROP

Some plans are offering backDROPs (sometimes called BacDROPs) whereby employees may choose at the time of actual retirement to elect a retroactive DROP. The pension plan calculates the amount that would have accrued during the period based on the accrued benefit as of the retroactive date and pays it as a lump sum at retirement. Employee contributions (plus interest) made during the retroactive period are returned as part of the lump sum DROP payment. However, the amount of the benefit is based on service credit and final average salary as of the retroactive date.

The Future

The Internal Revenue Service has granted tax qualification to public sector pension plans which have adopted DROP provisions. Private employer plans are subject to much more complicated tax laws, and, therefore, it is unlikely that DROP plans will be offered to members working for private or nonprofit employers.

A DROP plan can be adopted in the same manner as the pension plan itself, either legislated or negotiated. The legislative or negotiating process can be used to ensure that a proposed DROP plan include worker-friendly features, such as the ability to retire at any time between the minimum and maximum DROP periods rather than on a specific date selected in advance.

For more information on DROP, contact the Department of Research and Collective Bargaining Services at (202) 429-1215 or e-mail.

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