Deferred retirement option plans are becoming wide-spread in the public sector. While both employees and management find them appealing, their advantages and disadvantages should be weighed carefully. They provide significant lump sums to personnel and information that is useful to management in succession planning, staff retention and recruitment. However, DROPs are not typically cost neutral, and involve burdensome record keeping and enhanced communication services.
DROPs originated in Louisiana in 1982 and spread rapidly throughout the South, where police and fire representatives lobbied successfully for their adoption. In recent years, DROPs have become popular in all parts of the country and with all branches of government service. Four statewide pension systems include DROPs, and others are considering them. Many local law plans have been amended to include DROPS - 37 in Texas alone.
Are there analogues in the private sector? Employees retiring from private-sector plans must elect their forms of pension no earlier than 90 days before benefit commencement. DROPs usually entail a much earlier election, so private-sector plans cannot offer them. They can, however, offer partial lump sum options, which have many of the features of DROPs.
What is a DROP?
A DROP allows eligible employees to continue working while for pension plan purposes they have retired. Their pension benefit is frozen and their monthly pension benefits check, instead of being sent to them, is "deposited" into the pension plan. The employee agrees to continue working for a fixed period, during which the system credits to a hypothetical account the pension checks he would have received by retiring. This account is really just part of the plan's general assets and grows with interest at a stipulated rate. When the employee does retire (usually two to five years after electing this option), he receives the account balance as a lump-sum distribution, in addition to the monthly pension benefit that he had earned before electing DROP.
Costs and other burdens
Entering a DROP usually makes good financial sense for the employee when plan provisions such as benefit or service caps restrict his ability to earn future benefits. On the other hand, employees who expect large pay increases in the future should avoid DROPs so their pensions will reflect those increases. A participant eligible to enter a DROP must weigh the lump sum that it offers against consequences of participating, including giving up increases in monthly pension that would have resulted from future service and pay hikes.
DROPs offer several advantages to employers. They can help in succession planning by giving advance notice of when employees will retire. In some instances, they encourage employees contemplating retirement to stay a few years longer, giving the system the advantage of their experience and expertise. Also, the popularity of DROPs among employees may help employers in recruitment and retention efforts. In many programs the employer stops making contributions for an employee who enters a DROP.
The addition of a DROP greatly complicates plan administration, however, because it requires individual record keeping for its participants, keeping track for each participant of contributions and interest credits on a monthly basis. Most defined benefit pension systems are not equipped for this kind of record keeping. So plan administrators will find that DROPs suddenly and dramatically increase their workloads. Moreover, employees considering this pension option need accurate information to make informed decisions, so the plan administrator will have to supply detailed benefit illustrations.
Plan trustees considering a DROP should concern themselves with the potential cost (which varies widely with plan design) as well as with the additional administrative burden. Although often touted as cost-neutral, DROPs commonly add 2% to 3% of payroll to plan costs, depending on plan design.
In a partial lump-sum option, an employee might be allowed to elect to receive 10%, 25% or 50% of his accrued benefit as a lump sum. His monthly pension, which can take any form the plan provides, would be reduced to reflect this payment. This approach is much simpler to administer than a DROP and is usually cost-neutral. It does not, however, give the plan sponsor any advance notice of when employees plan to retire.
Several parameters significantly affect the cost of DROPs:
* Eligibility requirements. Limiting participation to employees who qualify for full pensions greatly reduces the cost of DROP benefits. Some plans are even more restrictive - requiring 30 years of service - and keep their costs down by preventing a DROP from becoming an early retirement enhancement.
* Amounts credited. Plans crediting only forgone pension amounts will come closer to cost neutrality than others will. Some plans credit only a portion, e.g. 80%, of the forgone pension payments in an effort to defray costs.
* Continuation of contributions. While those promoting DROPs often claim that the employer will not have to contribute on behalf of a participating employee, it is much easier to achieve cost neutrality if employer contributions continue throughout the DROP period. Likewise, cost neutrality can be achieved by continuing employee contributions and using accumulated employee contributions to offset the lump-sum amount that the employer-funded portion of the plan provides.
* Inclusion of cost-of-living adjustments. In plans with COLAs, the cost of a DROP can be significantly reduced by not adding COLAs to the amounts credited to DROP accounts. If COLAs are postponed until the year following actual retirement, the resultant savings will almost offset the entire cost of a typical DROP.
DROPs are popular with employees. But plan trustees should review design decisions carefully for unforeseen costs and drawbacks to determine whether a DROP would be a worthwhile addition to their retirement programs.
Charles E. Chittenden is a principal and consulting actuary in the Phoenix office of Buck Consultants Inc.