Deferred Retirement Option Plans (“DROP Plans”) (Posted on October 2, 2000 by )


Carol V. Calhoun, Counsel
Venable LLP
575 7th Street, NW
Washington, DC 20004
Phone: (202) 344-4715
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Carol V. Calhoun

  1. What is a DROP Plan?
    1. 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. 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.
    2. Example: 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 55 with 30 years of service, without actuarial reduction for the early retirement. If employee X had average final compensation of $20,000 a year at age 55, and had achieved thirty years of service at that point, she could retire immediately with a benefit of 2% x 30 (years of service) x $20,000, or $12,000. In the alternative, she could continue working until, say, age 60. At that point, she would have 35 years of service instead of 30, so the benefit would have gone up from $12,000 to $14,000, even if her compensation had stayed exactly the same. And of course, the benefit would have risen further if compensation had gone up between ages 55 and 60.

      A DROP plan would provide employee X with a third alternative. Instead of retiring immediately on a $12,000 a year benefit, or deferring retirement and getting a $14,000 annual benefit at retirement, she could elect to continue working for five years, but to have her compensation and years of service frozen at the level they were when she was 55. In exchange for her giving up the right to the continued accrual, her employer would agree to put $12,000 for each of the five years of her continued employment into a separate account under the retirement plan for her. When she ultimately retired, she would receive (a) $12,000 a year, plus (b) the value produced by taking the $12,000 a year credited to the account and increasing it by an earnings factor.

    3. Variations:
      1. A COLA or a “thirteenth check” (an additional payment each year equal to one month’s benefits) may be applied to the basic benefit.
      2. The employer and/or the member will make additional contributions to the account over the period of continued employment.
      3. The methods for crediting interest vary widely: earnings may be credited at a “formula rate” (e.g. the funding rate for the plan), at a fixed rate set forth in the plan, based on an independent index (e.g., T-bill rates), at a rate which depends on the discretion of the employer or some other party (e.g., the trustees in IRS Letter Ruling 9645031), or based on actual earnings (either of the plan as a whole, or of an individually directed account).
      4. 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.
  2. Advantages
    1. To the employer:
      1. 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 $20,000 a year by working full-time, yet could have received a $12,000 a year retirement benefit. Thus, she was getting only an extra $8,000 a year for working full-time over what she could have received for not working at all. Moreover, if employee X had switched to a job in the private sector, even one which paid only $15,000 per year instead of $20,000, she could normally have received the full $12,000 a year retirement benefit, in addition to her $15,000 salary. Thus, even though the private employer paid her less, her total income would be $27,000 a year, instead of the $20,000 a year she would make in her public-sector job.
      2. Often, 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.
    2. To the employee:
      1. A DROP plan is often quite popular with employees. It enables those employees who may have “maxed out” on the benefit payable under a defined benefit plan to continue to accrue benefits.
      2. Even for those who have not maxed out, the rate of accrual is often more favorable than continued accrual under the defined benefit arrangement.
      3. 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.
  3. Cost Considerations.
    1. A DROP Plan is typically actuarially neutral if only those employees who would otherwise have retired early elect the DROP feature.
    2. However, in a retirement plan which provides for a subsidized early retirement benefit, any employee who would have stayed even without the DROP feature, but who elects the DROP feature, typically raises plan costs.
  4. Legal Issues
    1. 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.
      1. 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. 415(c) that annual contributions cannot exceed the lesser of 25% of compensation or $30,000. Obviously, our example of the employee who was earning $20,000 a year, and having $12,000 a year credited to the DROP, would be impermissible if the DROP were being credited with actual earnings.
      2. If instead the DROP is credited with earnings at a stated rate, the DROP benefit is treated as part of the ultimate defined benefit for purposes of the maximum benefit limitations of Code Sec. 415(b). In general, these limits are less of a problem than the defined contribution limits, and for that reason among others, most DROPs are designed in such a way as to constitute defined benefit plans for Code purposes. However, even the Code Sec. 415(b) limits can be a problem for some highly compensatedemployees with long service-the exact ones to whom a DROP is likely to be most appealing.
    2. Definitely determinable benefit rule. Another issue is the “definitely determinable benefits” rule set forth in IRS regulations under Code Sec. 401(a). This rule requires that benefits under a pension plan be determinable from the plan document, rather than being subject to employer discretion. In many instances, it is hard to develop an appropriate interest rate for a DROP benefit, since commercial interest rates may fluctuate over the life of the DROP. However, a rate based on employer or trustee discretion may be considered to violate the definitely determinable benefits rule.
    3. Age Discrimination in Employment Act (“ADEA”). As discussed above, in many instances employees enter the DROP program based on an intent that they will in fact retire after a specified number of years. Entering the DROP program ceases normal benefit accruals, in favor of the special DROP benefit. One question is whether the decisions to retire at the end of the specified period, and/or to cease normal benefit accruals, can be made irrevocable without violating ADEA.
      1. To the extent that (a) the decision to enter the DROP program is voluntary, (b) there is no maximum age limit for entering the DROP program, and (c) the DROP program is not being used as a subterfuge for getting rid of older employees, a DROP program of itself would not create an ADEA violation, even though its effect would of course be to cause older employees (typically, the only ones eligible for DROP) to leave employment earlier than they otherwise might.
      2. However, certain features of a DROP program can cause ADEA issues. For example, if the program is available only between the earliest retirement age specified under the plan and normal retirement age, it would discriminate against employees based on how close they were to normal retirement age. Similarly, if the DROP program were presented in a way which raised other ADEA issues (e.g., notifying older employees that if they did not accept it, they would likely be laid off anyway without the security of the DROP program), it might be part of a pattern which as a whole could raises ADEA issues.
      3. The fact that the employee who is participating in DROP has not retired can also raise questions under ADEA. For example, if the employee had actually retired, s/he would not normally be entitled to disability benefits if s/he became disabled. However, someone who remains an employee and participates in DROP could potentially get the full economic effect under the pension plan of having delayed retirement, while still being eligible for disability benefits if s/he became disabled.
      4. At a minimum, employers should ensure that any employee who accepts the DROP program subject to a requirement that s/he terminate employment as of a certain date signs an appropriate resignation letter (effective as of the proposed date of termination) as part of the process of obtaining the DROP benefit, and that such letter complies with all of the ADEA requirements for waiver of ADEA rights. And of course, other employment practices must be examined to ensure that they do not combine with the DROP to create an ADEA violation.
      5. Many states have their own age discrimination statutes, in addition to ADEA. In general, the rule is that employees are entitled to their rights under ADEA and their rights under the state statute. Thus, an employer which complies with all the requirements of ADEA must still make sure that it complies with the corresponding provisions of applicable state law.
    4. Distribution rules.
      1. Although employees who are in a DROP program often view themselves as “receiving” the amount of the plan contribution each year, the contribution is not itself treated as a distribution. This has positive effects insofar as it avoids the 10% penalty tax on early distributions and income taxes on distributions. It also means that employees who have attained early retirement age but not normal retirement age can participate in a DROP program without violating the rule that a pension plan may not distribute benefits (other than amounts attributable to after-tax employee contributions) before the earlier of normal retirement age or termination of employment.
      2. However, the fact that the DROP contributions are not treated as distributions raises certain questions. First, the DROP contributions cannot be treated as fulfilling the required minimum distribution requirements under Code Sec. 401(a)(9). Although active employees are no longer required to receive such distributions, postponing the start of minimum distributions will increase the amount required to be distributed (possibly throwing the employee into a higher tax bracket) once the employee retires.
      3. Similarly, there may be a question as to who is the spouse for purposes of plan survivor or death benefits if the employee remarries between the start of the DROP program and actual retirement. At a minimum, the plan needs to be clear on how such situations will be treated.
    5. Social Security. Another consideration for lower paid employees may be the effect of a DROP on Social Security benefits. Amounts credited under a DROP, unlike normal wages, are not considered part of the wage base for Social Security purposes. For those employees who are close to retirement, the trade-off of the DROP program against the Social Security advantages which might accrue from having the employer simply pay higher cash wages instead may need to be considered.

Footnotes:
1. “Average final compensation” is typically defined as average compensation over the final three years of employment, although there are variants to this definition.
2. Note that in order for a discretionary interest rate not to fall afoul of the requirement that a pension plan provide definitely determinable benefits, the discretion must be exercised through an amendment to the plan adopted before the period to which the interest rate applies.
“Average final compensation” is typically defined as average compensation over the final three years of employment, although there are variants to this definition.
Note that in order for a discretionary interest rate not to fall afoul of the requirement that a pension plan provide definitely determinable benefits, the discretion must be exercised through an amendment to the plan adopted before the period to which the interest rate applies.