Be Cautious About “DROP” Programs

Public employers are growing increasingly skeptical of Deferred Retirement Option Plans. So-called DROP plans allow employees who would otherwise retire in a defined benefit plan to continue working. However, rather than continuing to accrue credit for their extra years of service, their pension is paid out alongside their usual salary but is credited to a separate account with a city-guaranteed interest rate. The employee typically receives the money in the account, including an agreed-upon interest amount, in a lump sum when he or she retires.  DROP plans were initially promoted as cost-neutral programs that would keep experienced employees around longer.  That optimistic outlook, however, is shifting.

The Los Angeles Times recently reported that Los Angeles’ DROP plan is distributing exorbitant payments to both retired and unretired public employees.  The Times explained that DROP plans are the reason behind the unusually high disbursements, including lump sum payouts upwards of $1.5 million.  This is because many employees participating in the City’s DROP plan, who must be at least 50 years old to participate, are taking unexpectedly long periods of medical leave.  This presents problems because it means that an employee on leave is collecting their usual salary while simultaneously depositing early pension checks in a special savings account with a high city-guaranteed interest rate.  The Times investigation pointed out that employees took injury leaves for an average of ten months, with hundreds more taking more than a year off.

The increasing unpopularity behind DROP plans is also because the lump sum payouts in conjunction with normal pension disbursements have shown a tendency to exceed the pension fund limits set by the IRS.  The IRS set the pension fund limits because the employer and employee contributions are not taxed and neither are the earnings on the investments.  After exceeding these parameters, Los Angeles was required to establish an “Excess Benefit Plan” to pay what the pension system cannot legally cover based on the IRS limitations.  For Los Angeles, the Excess Benefit Plan has paid $14.6 million to 110 retired employees since 2010.  According to the Times, this money could have been otherwise used for other city expenditures, including services and programs.      

The Times explained that when DROP payments exceed the IRS limits, the “payment is plugged into a formula that, for accounting purposes, spreads the lump sum over the retiree’s expected lifespan and determines how much of [a] monthly check should come from the pension plan and how much should be paid from the general fund.”  For one Los Angeles employee, the Excess Benefit Plan paid $144,000 of the $251,000 pension in 2017.  

While DROP programs exist elsewhere, they are becoming increasingly unpopular for public entities.  For example, San Diego and San Francisco tested out their own version of a DROP program, but they ultimately found the costs to be too problematic.

We recommend that public entities exercise caution in considering DROP programs and ensure that they establish a credible, thorough, and transparent review process.

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