Dear Actuary: What is a “DROP” pension plan and should my municipality have one?
- Intrigued in Irontown

Dear Intrigued:

First, let’s lay out the basics of what a DROP is and how it works. DROP is a funny-sounding acronym for deferred retirement option plan. A DROP is a feature within a defined benefit pension plan, most often seen in plans that cover police or firefighters. When a member elects to go into the DROP, the member’s pension benefit is calculated based on service and pay at DROP entry. For the duration of the DROP period, a percentage of the member’s calculated pension benefit is credited to a DROP account. The member continues to be an active employee during this time. At the end of the DROP period, the member retires and receives a lump-sum payment equal to the accumulated amount in the DROP account (often with interest) plus a lifetime pension benefit. The lifetime pension benefit is based on what the member had accrued as of the start of the DROP period, not as of the date the member exits the DROP and terminates employment.

Here is a simplified example. Suppose a plan’s annual pension benefit is equal to 2% of final pay for each year of service. A member has 25 years of service and pay of $80,000, so the annual pension benefit is 2% x $80,000 x 25 years = $40,000 per year. The plan’s DROP provisions specify that 100% of the accrued benefit is credited to the DROP account, and the DROP does not credit any interest. Suppose the member elects to participate in the DROP for a three-year period; that is, the member works for a total of 25 + 3 = 28 years. At the end of the three years, the member retires with an annual pension benefit equal to $40,000. In addition, the member receives a lump-sum payment of the amount that has built up in the DROP account: 100% x $40,000 x 3 years = $120,000.

You might be wondering why a municipality would want to implement this kind of feature. Employees like it because it lets them get a significant lump sum at retirement as well as collect a lifetime pension benefit. Plan sponsors like it because it is helpful with workforce planning – the employee is essentially announcing his or her retirement several years in advance so the employer can start to look for and train a replacement.

A critical issue with a DROP plan is whether it results in an additional cost to the plan, or conversely, lower benefits for the member. A DROP feature can be designed so that on average, the cost to the plan is the same regardless of whether a member elects to participate in the DROP or not. But the key phrase there is on average. For any one member, a DROP election will likely have either a cost or a savings to the plan, meaning it would result in somewhat higher or lower benefits paid to the member over their lifetime.

Consider the member in our previous example. What if the member retires with 28 years of service, like before, but without participating in the DROP? The member won’t receive any lump-sum payout, but the member’s annual pension benefit will be higher because it will reflect three more years of service plus likely a higher pay amount. Suppose the pay at the end of the three-year period is $88,000; the annual pension benefit would therefore be 2% x $88,000 x 28 = $49,280. So, which is better: a lump sum of $120,000 plus an annual pension of $40,000 if the member elects the DROP or no lump sum plus an annual pension of $49,280 without the DROP? The answer depends on how long the member will live and collect that pension, and actuaries can quantify that by calculating the present value of both options, taking into account the individual’s life expectancy as well as the time value of money:

As the numbers illustrate, this particular member gets a higher value of benefits by electing to participate in this DROP. But a second member in the same plan, with the same service and the same pay level, might have a lower value of benefits if the second member is older than the first one and therefore has a shorter remaining life expectancy.

Across an entire plan, there may be individuals for whom a DROP election results in a higher value of benefits and therefore costs the pension plan money, and others for whom a DROP election results in a lower value of benefits and therefore saves the pension plan money. That is, a DROP plan is rarely cost neutral for any given individual, but across an entire plan population a DROP plan might be cost neutral if individuals with higher values are largely balanced by individuals with lower values. Cost is an important consideration and something the plan’s actuary should analyze during the plan design phase.

Your actuary can do an analysis showing the cost or savings for members at different ages and lengths of service. You can then tweak the DROP features to achieve an expected cost of zero. Figure 3 illustrates this kind of analysis. The table compares the present value of retirement benefits if the member elects to DROP to the present value of benefits if the member retires at the same point in time but without a DROP. In other words, it is a comparison of the two bars in Figure 2 for a variety of sample members. Negative numbers indicate a lower present value with the DROP and therefore a savings to the plan.

Speaking of DROP features, there are several different questions to answer, all of which impact the cost of the DROP:

• When are members eligible to participate in the DROP? A plan might set both a minimum and a maximum age and/or service requirement.
• How long is the DROP period? The range is typically one to five years.
• Does the member need to select the DROP period when they enter the DROP? If so, can the member elect to extend the DROP period?
• What percentage of the accrued pension benefit is credited to the DROP account?
• Will interest be credited to the DROP account? If so, at what rate?
• Will the DROP account monies stay within the pension plan’s assets, or will they be transferred to an individual defined contribution account and invested at the member’s direction?
• If employees make contributions to the plan, will they continue to make contributions during the DROP period?
• If the pension benefit is subject to cost of living increases (”COLA’s”), will those increases apply during the DROP period?

A DROP design should also address what happens if an employee becomes disabled or dies during the DROP period, or needs to retire before the end of the DROP. Typically, in these situations the DROP election is essentially cancelled, and the plan benefits are calculated as if that election never took place. How the employee is treated for the purpose of any other employee or post-employment benefits should also be stated in the plan or contract language.

If you like the idea of providing members with a partial lump sum at retirement but are looking for ways other than a DROP to accomplish this, there are a few options to consider. The lump sum amount could be set equal to one of the following, and the lifetime pension benefit would then be reduced such that the overall present value of the combined benefits is the same both with and without the lump sum:

• Lump sum = member contributions with interest
• Lump sum = actuarial present value of 10% (or 15%, 20%, etc.) of future lifetime pension benefits.
• Lump sum = x times the original monthly benefit, where x can be fixed or selected from a range such as 12 to 36.
• Lump sum = actuarial present value of future COLA payments; the member’s lifetime pension benefit would then not grow with any future COLAs.

If you are interested in learning more about DROPs or other approaches to lump sum payments, or if you would like to model various plan designs for your community, reach out to your actuary. And, as always when you consider changes to the plan’s benefits, you should consult with legal counsel.

- Your Milliman Actuary

This edition of Dear Actuary was written by Yelena Pelletier, ASA.

For more Dear Actuary articles, see prior letters here.

Do you have a question about your defined benefit pension plan? Write to us at [email protected].