Deferred Retirement Option Plans (“DROP” Plans)In recent years, many retirement plans, particularly those operated by state and local governments, have adopted some form of deferred retirement option, or . This article discusses what a DROP plan does, what the attraction of a DROP plan is from the perspective of both the employer and the plan member, and the legal and actuarial issues raised by DROP plans. What is a DROP Plan? In its simplest terms, a DROP plan is an arrangement under which an employee who would otherwise be entitled to retire and receive benefits under an employer’s defined benefit retirement plan instead continues working. However, instead of having the continued compensation and additional years of service taken into account for purposes of the defined benefit plan formula, the employee has a sum of money credited during each year of the continued employment to a separate account under the employer’s retirement plan. Deferred Retirement Option Program (DROP). FRS offers the Deferred Retirement Option Program (DROP). State University are administered by the State of Florida Division of. Florida State University (FSU. The account earns interest (either at a rate stated in the plan, or based on the earnings of the trust underlying the retirement plan). The account is paid to the employee, in addition to whatever benefit the employee has acquired under the defined benefit plan based on earlier years of service, when the employee eventually retires. An example may make the arrangement easier to understand. Suppose that employee X is covered by a retirement plan which provides that she will receive an annual benefit beginning at retirement of 2% of average final compensation times years of service. Suppose further that the retirement plan permits employee X to retire as early as age 5. If employee X had average final compensation of $2. In the alternative, she could continue working until, say, age 6. At that point, she would have 3. And of course, the benefit would have risen further if compensation had gone up between ages 5. A DROP plan would provide employee X with a third alternative. Instead of retiring immediately on a $1. In exchange for her giving up the right to the continued accrual, her employer would agree to put $1. When she ultimately retired, she would receive (a) $1. Within this basic format, plans may implement many different options. For example, in some instances a COLA or a . In some instances, the employer and/or the member will make additional contributions to the account over the period of continued employment. The methods for crediting interest vary widely: earnings may be credited at a . In some instances, the member can obtain the DROP benefit only by foregoing the right to continued employment at the end of the DROP period. To the extent that employers are initiating DROP Plans, the major reason is a concern about the ability to retain valued employees who are eligible to retire. Many governmental plans, either as a matter of plan design or due to inadvertence, contain substantial incentives for employees to retire early. For example, employee X was making $2. Thus, she was getting only an extra $8,0. Moreover, if employee X had switched to a job in the private sector, even one which paid only $1. Thus, even though the private employer paid her less, her total income would be $2. In many instances, situations like that of employee X arise because the employer (or the plan to which the employer contributes) wanted at some point to encourage early retirement.
This is particularly true in the case of public safety employees (who may lack the physical stamina to keep up with their demanding jobs at later ages) and teachers. During the teacher surpluses of earlier years, many school systems tried to get more experienced (and therefore more highly paid) teachers off the payroll to make way for less experienced (and therefore less expensive) replacements. However, in many instances employers have found that they have thereby discouraged some of their most loyal and productive employees from continuing to work. Why Do Employees Like DROP? In some instances, an employer adopts DROP as a result of pressure from employees or unions, or as a tool in labor negotiations. A DROP plan is often quite popular with employees. It enables those employees who may have . Even for those who have not maxed out, the rate of accrual is often more favorable than continued accrual under the defined benefit arrangement. In many instances, the DROP benefit is payable as a lump sum (always a popular feature with employees), while the defined benefit is available only as a lifetime annuity. In order for a DROP Plan to be successful there must be a give and take between the employers and employees. As noted earlier, the DROP Plan enables an employer to retain valuable employees and enables the employee to accumulate a larger pension than would otherwise be payable under the existing defined benefit pension program. DROP (Deferred Retirement Option Plan)., OP&F has put in place a beneficial program without. Enrolling in DROP is a voluntary decision that.But at what cost? Actuarially neutral design. Most simply put, increases in pension benefits above those currently provided cost more money. Many DROP programs strive to be . Actuarial costs, however, are only truly measured with experience. If, for example, the addition of a DROP program causes employees to begin to retire earlier, then the cost to the employer will necessarily increase since pensions will need to be funded over a shorter period of time. On the other hand, since employers generally fund retirement programs over the working lifetime of the participants, employer contributions would be expected to continue until the employee actually stops working. But if the plan is designed that when a DROP option is chosen, an employer ceases to make pension contributions for the employee, then the employer has an immediate contribution savings during the DROP period. The effect of demographics on design. Of course, all bets are off if the underlying retirement program provides actuarially subsidized early retirement benefits, a common practice in the governmental plan arena. Subsidized early retirement benefits (that is, benefits for early retirements which are unreduced or reduced less than actuarially neutral benefits) produce an increased cost to the employer. When an employee who is eligible for a subsidized early retirement benefit decides to continue to work for another year, the pension plan experiences an actuarial gain since it need not provide the pension payments for that year. The longer the employee continues to work, the larger the actuarial gain to the plan. These actuarial gains serve to lower the ongoing employer cost of the plan. But examine what happens with the addition of a DROP program. From the pension plan’s viewpoint, when an employee chooses the DROP option, it is exactly as if the employee has retired since actual pension payments will begin. If the pattern of incidence of retirement changes under the DROP Plan, then from an actuarial standpoint, the assumptions concerning retirement may need to be revised to take this actual experience into consideration. Using lower assumed retirement ages will result in higher required contributions to properly keep the plan in balance. Most government plans mandate employee contributions which are used to offset the employer cost of the plan. Design choices regarding these contributions can affect the ongoing cost of the retirement program. If the employee contributions continue during the DROP option period, the employer contribution continues to be offset. But, if the employee contribution ceases at DROP choice or is also deposited into the DROP account, then the total cost portion normally funded by the employee must come from the employer. The effect of investment return on design. Defined benefit pension programs benefit not only from retirement gains, but also from investment gains. The actuary, in preparing cost calculations, assumes that assets will earn a stated net investment return. Since employers bear the risk of investment in defined benefit plans, to the extent that the plan assets earn a rate higher than that assumed by the actuary, the fund experiences an actuarial investment gain which serves to lower the ongoing employer contribution. Compare this to the defined contribution arrangement, where the amount of benefit received by the employee is directly related to the employee’s account balance and this account balance is credited with the actual investment return of the fund. If a DROP Plan credits interest based on actual earnings, then the employer has passed on the full investment risks to the employee. Therefore, in a strong investment market, the employer’s cost for the remaining defined benefit program will increase as there are no investment gains to offset the pension cost. In a weak market, the employee’s ultimate total pension benefits could be less than if the DROP option were not chosen. A numerical example. In our earlier example, if the DROP were chosen, Employee X would have an additional lump sum of $6. The present value of the future payments under option 2, assuming a 3. The present value of the future pension payments under option 1 is about $1. The net gain to Employee X of exercising the DROP (option 1) is $3. It seems as if the employee is the big winner in a DROP Plan. Why is this so? In our example, the early retirement benefit is subsidized, that is, there is no actuarial adjustment for taking the benefit at age 5. In order for our example to produce an . Neither of these adjustments are particularly common in governmental plans. Bigger benefits cost the employer more and DROP plans generally provide bigger benefits. Legal Issues. Contribution limits. As noted above, the earnings crediting on a DROP can take several different forms. The way in which earnings are credited will affect the legal rules applicable to the plan. If interest is credited based on actual earnings, either of the plan as a whole or of an individually directed account, the portion of the plan which represents the DROP accounts is treated as a separate defined contribution plan. As such, it is subject to all of the rules applicable to defined contribution plans, including the rule in Code Sec.
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