GFOA Advisories identify specific policies and procedures necessary to minimize a government’s exposure to potential loss in connection with its financial management activities. It is not to be interpreted as GFOA sanctioning the underlying activity that gives rise to the exposure.
Numerous governments have added deferred retirement option program (DROP) features to defined benefit plans. In some instances, DROPs were established with the stated goal to achieve certain financial and human resource management objectives, the most common being employee retention beyond their otherwise anticipated retirement age. In other cases, DROPs were negotiated as a pension benefit enhancement.
DROPs can vary significantly, but usually include a lump-sum payout in addition to an employee’s pension. DROPs allow employees who are eligible to retire from a defined benefit plan to instead continue working and elect to participate in the DROP. During DROP participation, employees do not accrue additional service or increased compensation in the defined benefit formula. Instead, all or a portion of the employee’s benefit is credited to the employee’s notional DROP account (“the DROP account”) in the retirement plan. When employees ultimately retire, they typically receive the balance in the account, including interest credits, in a lump sum in addition to the monthly pension benefit accrued at the start of DROP participation. Essentially under a DROP, employees who qualify for a pension benefit are able to continue working while at the same time begin receiving their pension benefits in a deferred account.
GFOA recommends that government defined benefit plans do not include DROPs for the following reasons:
1. The cost impact of a DROP is difficult to assess. DROP plan provisions blur the distinction between active participation and retirement and the impact on plan costs is not always readily apparent. This lack of transparency in plan cost is the result of two primary factors:
- Most plans do not assume 100% retirement at first eligibility but assume different retirement rates at different eligible ages. If a plan permits an election to participate in the DROP without leaving employment and the provisions are beneficial to the employee, more members will likely enter DROP than otherwise would have been expected to retire. This effectively means members are starting their benefits earlier, which under many plan designs will increase plan costs.
- Testing the cost impact of a proposed or implemented DROP requires making assumptions about when members would have retired without the DROP. Such assumptions cannot be tested by experience, because the presence or absence of the DROP impacts the real-world retirement decisions that employees make. Furthermore, economic conditions, health insurance coverage, and other factors may drive changes in retirement utilization that make it difficult to isolate the effect of the DROP on retirement decisions.
How a DROP impacts retirement patterns may be difficult to accurately assess. Therefore, claims that a specific DROP is “cost neutral” or will not increase the employer’s cost of funding the pension plan should be viewed with caution because in many well documented instances, costs have been substantially higher than anticipated for the sponsoring governments. In addition to the cost impact on the pension plan, if the DROP results in increased retention of experienced employees, higher salary and benefit costs should also be expected.
2. DROPs may conflict with goals of pension design. Defined benefit plans are designed to provide lifetime retirement income and an orderly transition between generations of workers. DROPs often reduce lifetime income replacement in exchange for a lump sum at retirement.
Many government pension plans provide financial incentives that encourage retirement at a relatively early age and short term of service. The decision to offer a DROP, which extends employment, and widespread participation by employees, is strong indication of both an employee and employer desire for longer terms of employment. If the design of the pension plan does not align with the expected or desired career length, then the plan should be reviewed and amended for better alignment.
DROPs are sometimes implemented to avoid a workforce shortage or to minimize the cost of training new employees by retaining experienced ones. However, workforce demographics change over time and what was once a shortage may become a glut of employees at a specific level. In some governments, pension provisions cannot be modified for existing employees and may result in a DROP working against changing workforce management objectives. Even in the absence of constitutional protections of the benefit structure, governments that intend to implement a DROP for a limited duration may face significant pressure to maintain those features. Governments seeking to address workforce conditions through a DROP are encouraged to seek strategies that exclude pension plan features and more directly target the specific workforce goal. A DROP can also cause difficulty in communicating benefits to employees and cause workforce morale and equity issues to employees if the DROP is not available to the entire workforce population.
3. Employee choice frequently increases employer cost. If employees are given a choice between two or more plan features – such as electing a DROP, retiring, or remaining active without electing the DROP, employees are likely to elect the option that they believe will be the most beneficial to them. 2 This often results in higher overall plan costs. Additionally, if the duration that employees can continue to receive credits in the DROP is unlimited, the employees are likely to select the duration that provides the most benefit to them, which also results in the highest cost to the plan. Common DROP features that can provide employees options to maximize benefits and increase plan costs include:
- Length of DROP election period;
- Length of DROP participation while employed;
- Continued DROP participation after termination;
- Distribution options;
- Availability of retroactive DROP election (Back DROP); and
- Partial Lump Sum Option (PLOP).
4. Specific DROP characteristics and features often add additional cost. DROPs have far-reaching financial and operational impacts for the government and certain DROP features typically add additional cost, complexity, and other potential negative outcomes. Common examples include:
- Extensive enrollment period for DROP election;
- Retroactive DROP elections whereby employees can elect the DROP at the end of the period of DROP participation;
- Credit for all or most of an employee’s earned benefit credited to DROP account;
- Misalignment between the interest credit to the DROP account and the actual return on the plan’s assets;
- Extensive length of participation during continued employment;
- Extended distribution timing options;
- Availability of lump sum DROP account distribution on demand and potential for liquidity concerns; and
- Permanence of DROP.
5. Partial lump sum option plans (PLOPs) considerations. With regard to partial lump sum option plans, there are several considerations:
- Partial lump sum option plans allow employees to make an election at retirement to take a portion of the otherwise payable retirement benefit as a lump sum and the remainder as an actuarially reduced monthly benefit.
- Partial lump sum option plans are often considered a DROP, but do not share all the potential drivers of cost (opportunities to elect different options during employment) that are inherent in DROPs.
- Partial lump sum option plans may depart from the primary purpose of a defined benefit plan, to provide monthly income in retirement, but typically only increase costs to the extent adverse selection occurs.
- Definition of DROP used in this best practice is based on Carol V. Calhoun and Arthur H. Tepfor, Deferred Retirement Option Plans ("DROP" Plans), Pension & Benefits Week, October 13, 1998.
- Difficult of assessing costs for DROP plans is based on Samson Alva, Norma B. Coe, and Anthony Webb, The Impact of Drop Program On The Age of Retirement And Employer Pension Costs. Center for Retirement Research at Boston College, September 2010.