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

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 economic value of pension benefits to DROP retirees, (2) there are more DROP winners than DROP losers, and (3) the actual age at which employees retire is younger than anticipated by the DROP retirement assumptions. The recently publicized cases in which DROP costs ballooned far beyond what had been anticipated involved one or more of these factors.

The eligibility of employees for death or disability benefits during the DROP period is typically based on whether the plan design considers the DROP participants active or retired. If DROP participants are treated as continuing, active members, they typically continue to make required member contributions during the DROP period and retain their eligibility for any ancillary benefits. If a qualifying event occurs, they are treated as if they never elected the DROP. Alternatively, if DROP participants are treated as retirees, they typically cease making required contributions and are no longer eligible for ancillary benefits. This is an important consideration for plans that provide enhanced benefits for a service-related death or disability, such as one covering public safety workers.

WHY CONSIDER A DROP?

From the perspective of most employees, a DROP pays a significant lump sum upon employment termination in return for service beyond the retirement plan's normal retirement date. Upon reaching retirement age--a time when health care costs often rise substantially--many employees find less than stellar investment results in their 457 or 403(b) accounts. Delaying retirement for a few years thus becomes a reasonable solution. The accumulation of a lump-sum benefit over the period that eligible employees defer retirement offers an enticement that has kept the utilization rates of most DROPs very high. Many employees consider the DROP a "no lose" option when, in reality, they can end up with less in total retirement benefit value than they otherwise would have earned through continued service accruals.

For employers, a DROP offers a number of benefits, the most important of which are discussed below.

Employee Retention. A forward DROP can be designed to provide an incentive to keep retirement-eligible employees working. The ability to retain workers can reduce an employer's training and recruitment costs and can lower retiree medical costs by deferring the payment of other postemployment benefits. On the negative side, the employer has no discretion in selecting which employees elect the DROP and which do not, so the DROP can have the effect of prolonging the employment of workers the employer would rather not retain. In keeping some of these employees, employers sometimes encounter ill will or morale problems because of limited promotions and additional work opportunities for other employees.

Enticement to Leave. A back DROP can be structured to lure employees into terminating employment. A lump sum in addition to a monthly pension may help ease the transition to retirement for some employees. However, a DROP typically reduces the effectiveness of early retirement incentives that an employer also may offer.

Succession Planning. With a forward DROP, management knows when employees who elect the DROP will retire, thereby facilitating planning for replacements. On the negative side, a DROP "accumulates" retirement-eligible employees. Economic events or policy changes (such as a salary freeze) could result in more job vacancies than can possibly be filled if DROP participants terminate en masse.

ECONOMIC VALUE TO EMPLOYEES

DROP provisions vary greatly. As in the case of early retirement incentives, the larger the enticement offered in a DROP, the greater the number of participants. And like early retirement incentive programs, the economic value of a DROP to an employee will depend more on the individual's demographics--particularly age and years of service--than on the DROP design.

Age. Because younger retirement-eligible employees have a longer retired life expectancy than older employees, their economic interests are better served by working additional years without the DROP option, thereby increasing the amount of their annual pension. Conversely, older employees are generally better off taking the DROP with a lump sum and receiving lower annuity benefits.

Service. Employees with short tenures get a significant percentage increase in their accrued benefit with every year they work beyond retirement eligibility. Therefore, working additional years without the DROP is more beneficial than opting for the DROP. Conversely, employees with many years of service do not get a large percentage increase in their accrued benefits and are therefore generally better off taking the DROP. This is particularly true for employees who have already hit the benefit multiplier cap (usually 30 years of service) and thus can only increase their accrued benefits through salary growth. These employees give up very little in the way of additional benefit accruals and gain the benefits accumulated in the DROP account.

Salary increases, to a lesser degree than age and service, also can be a factor in the economic value of a DROP. If the salary increases of an employee are anticipated to be relatively small, the accrued benefit will increase marginally because of the change in the employee's final average pay during the DROP period. This enhances the economic value of the DROP to the employee.

Because a typical DROP results in a total benefit value that is different from what the employee would have otherwise accrued without the DROP, some employees will be DROP 'Winners" and others DROP "losers," while a few, solely through coincidence, will break even.

A DROP is cost neutral on an individual employee basis if, and only if, the actuarial present value of the benefit does not change regardless of whether the employee elects the DROP. If an employee does not elect the DROP, he or she receives the benefit accrued as of the end of the DROP period and payable at that point. If the DROP is elected, the employee receives the accumulated amounts in the DROP account plus an annuity equal to the benefit accrued as of the beginning of the DROP period, but paid out starting at the end of the DROP period. The DROP-electing employee thus foregoes increases in the accrued benefit during the DROP period in exchange for receiving benefits (via accumulation in the DROP account) during the DROP period. This is shown in Exhibit 1.

In this simple example, the DROP has a higher actuarial present value than if the employee does not elect the DROP, which means greater economic value to the employee and higher costs to the pension plan. If the two options had the same actuarial present value, the two bars would be equal and the DROP would be cost neutral. This test of cost neutrality is fairly simple to perform for an individual exiting DROP once all the necessary information is known (i.e., age and service at DROP entry, actual length of DROP period, actual salary increases, etc.), but can be difficult to assess before DROP entry.

COST IMPACT ON EMPOLYERS

Most of the early DROPs were designed for small- to mediumsize public safety plans. For many of these plans, the actuaries commonly assumed that employees would retire upon becoming eligible for normal retirement. Because the actuaries conservatively valued the most expensive case for each employee (i.e., unreduced retirement benefits beginning at the earliest possible age), a DROP could be added without affecting the required funding for the plan. In fact, in these early DROP designs, both the employer and the employee commonly ceased making contributions to the plan once a DROP was elected. Due to the special circumstances (i.e. conservative retirement assumptions) surrounding these early designs, employees and employers viewed DROPs as inherently cost neutral and the adoption of DROPs began to spread nationally.

DROP advocates argue that pen sion plans do not pay a DROP retiree any more than what would have been paid had he or she retired instead of electing the DROP. Although this may be true, the assessment of a DROP's cost neutrality requires more than comparing the benefit amounts alone; it depends on the actuary's assumption about when retirement will occur.

In a more complex or larger pension plan, the actuary typically develops an assumption for the probability of an employee retiring at each eligible retirement age, based on the plan's prior retirement experience. Therefore, the actuary already assumes that a percentage of employees work beyond the first eligible age for normal retirement. These age-related retirement probabilities may extend for 15 to 20 years after the first eligibility age. In attempting to assess the future cost impact of a DROP, the actuary may anticipate a change in the retirement behavior of eligible employees and recommend an alteration to the retirement assumption. If the anticipated change in behavior does not materialize, the actual cost of the DROP will be different than expected.

A pension plan's liabilities will be unfavorably impacted if (1) the DROP increases the economic value of pension benefits to DROP retirees, (2) there are more DROP winners than DROP losers, and (3) the actual age at which employees retire is younger than anticipated by the DROP retirement assumptions. The recently publicized cases in which DROP costs ballooned far beyond what had been anticipated involved one or more of these factors.

In Milwaukee County, for example, the use of a back DROP design enabled employees to retroactively select the benefit of greatest economic value. For this very reason, the back DROP design often results in far more winners than the forward DROP. For the first two plan years, 35 percent and 64 percent of eligible employees elected to use the DROP option - much higher than the 25 percent utilization rate the county had forecast. To make matters worse, a major and lengthy decline in the equity markets occurred during this same two-year period. In the end, the county paid a lot more than it had anticipated, the county executive and seven supervisors lost their jobs, and the human resources director went to jail.

How do you design a DROP program that is cost neutral? DROP design features that work toward cost neutrality include the following:

* Eligibility requirements that take into account the demographics of the employees the employer wants to entice toward electing the DROP

* An interest rate below the actuarial funding rate to be credited to the DROP account

* Continued employee contributions during the DROP period

* Deferral of cost-of-living adjustments until actual retirement

* Deposits of a percentage (such as 85 percent or 90 percent) of pension benefits into the DROP account rather than the entire amount

Before implementing a DROR the plan's actuary should examine whether the DROP is expected to change retirement patterns and how sensitive the plan costs are to changes in the retirement assumptions. In some cases, a survey of retirement-eligible and near-retirement-eligible employees can provide an indication of the demographics of future DROP participants and the basis for considering an expected range of utilization and retirement behavior change.

Either through modeling or actuarial analysis, the actuary should test multiple scenarios of outcomes on each plan design (e.g., best case, good case, likely case, bad case, worst case).' Performing this type of scenario testing beforehand will help prevent the embarrassing and financially damaging "surprises" experienced by Milwaukee County and other local governments over the last few years. Just as importantly, scenario analysis helps educate decision makers so that they are able to weigh, in a risk and reward fashion, the design features that are most appropriate for the goals they want to achieve through the DROP.

PARTIAL LUMP-SUM OPTIONS (PLOPS)

An alternative to a DROP, a Partial Lump-sum Option Plan (PLOP) may satisfy the desires of employees to receive a portion of their benefit in a lump sum at termination without the plan sponsor risking the potential increase in actuarial liabilities under a DROP. A PLOP is simply an optional form of payment that allows the employee to take a partial lump sum at retirement and begin receiving an actuarially reduced monthly benefit. PLOPs are offered in conjunction with other optional benefits (such as joint-and-survivor options) and typically limit the lump-sum amount to no more than 36 monthly payments.

For example, at age 55 and with 30 years of service, Pat has accrued an annual retirement benefit of $57,000. He can elect a 24-month PLOP that would give him a lump sum of $104,000, along with an actuarially reduced monthly annuity benefit. Because the accrued monthly retirement benefit is actuarially reduced to account for the value of the lump sum received, the PLOP election has no cost implication for the plan.

Some PLOP designs require employees to delay retirement to be eligible. For instance, they must defer retirement for at least the number of months they would like to receive benefits in a lump sum. In this case, a member wishing to receive 24 months in a lump sum must delay retirement for at least 24 months beyond the normal retirement date. This type of PLOP design can help an employer achieve its worker retention goals.

WORKING AFTER RETIREMENT (WAR)

Another alternative to a DROP is to allow targeted employees to return to active employment after they have retired, perhaps to the same position. Such action typically requires a break in service or a waiting period before the employee is allowed to return to work. Oftentimes, the position must be classified as a "critical shortage" position. A WAR employee receives both a regular pension benefit on top of a salary and some, if not all, of the fringe benefits offered in active employment. Where WAR is allowed, the trend has been toward shorter required breaks in service and/or an expanded classification of critical shortage areas. A distinct advantage from the employer's perspective is its ability to exercise discretion over the re-employment of retirees. In most cases, WAR has the effect of decreasing the plan's average retirement age and results in an unfavorable cost impact. Plan sponsors contemplating a WAR option should thoroughly investigate the regulatory, administrative, and funding implications.

CONCLUSION

Designing and implementing a DROP that meets the desires of both the employer and employee within required cost constraints is achievable. Even if a DROP is determined to be unsuitable, an actuarial equivalent alternative, such as a PLOP, may be a good fit. The number of experience studies on defined benefit plans with a DROP feature is rapidly growing, and actuaries are using this information to analyze DROP proposals. Although the experience of one plan does not directly correspond to another's, it can assist with determining the boundaries of reasonable expectation. GFOA's recommended practice on DROP takes into consideration the experiences of local governments across the country and includes helpful guidance on determining the suitability of a DROP.

Note:

(1.) To help actuaries with their analysis of DROPs, the Society of Actuaries published a 2003 monograph entitled Design and Actuarial Aspects of Deferred Retirement Option Programs.

RELATED ARTICLE: GFOA on the use of drops.

Governments should exercise caution in considering whether to offer a DROP to their employees. If a government elects to do so, it should conduct a review that includes an assessment of the DROP's goals and an analysis of plan design, features, and cost.

The goals should be documented and not conflict with other retirement plan provisions (e.g., DROP retention goals should not be at odds with early retirement incentives). A statement of goals is needed to judge the ultimate success of the initiative and to develop performance measures.

Because a DROP creates a need for greater liquidity (i.e., DROP account lump-sum payments), a government should perform additional portfolio analysis to ensure investments produce sufficient income to meet liquidity needs.

Governments should evaluate the effectiveness of the DROP after it has been implemented to determine if the program goals were met. They should consider including a sunset provision for the program and determine whether it should be continued, modified, or terminated.

Source: GFOA Recommended Practice, "Deferred Retirement Option Plans" (2005).

ROBERT DEZUBE and JOHN GARRETT are consulting actuaries in Milliman's Washington, D.C. office. Both have extensive experience consulting with state and local government retirement systems.
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Title Annotation:retirement planning
Author:Dezube, Robert; Garrett, John
Publication:Government Finance Review
Geographic Code:1USA
Date:Dec 1, 2005
Words:3421
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