Time to Drop DROPs

Alice-in-Wonderland math can't work for Deferred Option Retirement Plans.
by | June 4, 2009

Some public-sector pension funds morphed into mutants in the 1980s. The transformation started with a simple issue: In many major pension plans for teachers, police and firefighters, an employee could "max out" under the lifetime payment formula at a fairly young age; the cost of replacing them could be higher than keeping them on payroll. The solution many plans came up with was to craft an appendage to the pension plan -- a Deferred Option Retirement Plan, or DROP. There are several varieties of the DROP features, but they all provide incentives for employees to keep working and to collect extra money in an individual "side account." In most cases, the employee foregoes any additional increases in pension benefits, and often makes no further contributions into the pension plan proper.

The mere existence of a DROP plan should signal that something is wrong with the pension plan. The idea of providing incentives to seniority workers to keep them in service -- because their pension plan encourages a life of leisure well before age 60 -- is a signal that the pension benefit is simply too rich. But early retirement plans with full lifetime benefits are simply not sustainable in today's world of increased longevity, shrunken government budgets and underwater pension fund portfolios. While most workers in the private sector must now toil until or beyond age 65 because their 401(k) accounts are insufficient to retire, the public sector continues to act as if nothing has changed in the world around them. Further sweetening the pot with what some might call a bribe to remain working is a Mad-Hatter-meets-Rube-Goldberg scheme.

When DROP plans first appeared, there was justifiable skepticism among many public managers. Advocates' claims of "Something for nothing" just didn't ring right. In most cases, unions -- not management -- pushed for DROPs. Sympathetic actuaries, often recommended by unions, declared that the costs of these arrangements would be actuarially neutral and not create yet another taxpayer-financed boondoggle. Sometimes the resulting plan designs actually met the financial-fairness test and created no added costs -- even if they failed to reform the original problem of excessive benefits.

But in many cases, the suspicions of early cynics proved correct, and these DROP plans have been nothing more than another way for employee organizations to outwit politicians and public managers -- and siphon money off the pension fund. As this reality sets in, concerned elected officials are slowly awakening. San Diego Mayor Jerry Sanders is one leader who has called for reforms, as the price tag there has become more obvious. Local media in other states have also called for reform or elimination of DROP plans.

Milwaukee County officials uncovered a massive actuarial deficiency and sued their pension actuary for misrepresenting the actual costs of their DROP plan. News reports there of a $45 million settlement should alert pension professionals nationwide to the financial liabilities they could face if they fudge the numbers or their assumptions prove wrong in later years. Industry observers now expect far greater due diligence and documentation of client communications and cost projections in the future, as these kinds of liabilities could quickly raise the costs of actuarial services in this market sector.

One of the common features of DROP plans is the payment of interest to employees on money deposited into an individual account in their name but held by the retirement plan. Instead of paying interest at a rate appropriate for short-term savings, or letting the employee invest at-risk in a self-directed investment account, many pension plans have been paying a guaranteed interest rate on DROP accounts equal to their expected long-term earnings rate on investments such as stocks and bonds. On its face, this is an imprudent practice. Who wouldn't want to collect 6, 7 or even 8 percent guaranteed on a 5-year deposit in their IRA or 401(k) plan, or their bank account? And what bank or insurance company would accept such terms?

Pension funds that allow these sweetheart arrangements accept all the risks and costs of a short-term liability that the employee can convert to cash -- not a long-term liability similar to a pension promise. Nobody in the private sector would underwrite such a liability with a stock portfolio, because the long duration of the investment is not matched to the shorter-term liabilities. That shifts all market risk to the pension plan and the taxpayers. It would be like investing a 14-year-old child's college savings in a stock mutual fund and hoping that the market always achieves its average return every five years, even if the bills come due when the market is down.

Yet we see pension funds paying interest on DROP accounts as high as 8.5 percent. Needless to say, the plans that paid such generous guaranteed interest rates in the past 10 years have suffered huge underwriting losses on their "DROP business line." If they were insurance executives, the participating pension trustees and plan administrators would be dismissed as incompetent, and their actuaries would be fired and unable to find work elsewhere. Yet in the public sector, these practices persist.

As the nation's financial crisis puts increasing pressure on pension funds, one of the first reforms to consider is the suspension or redesign of DROP plans that operate on Alice in Wonderland principles.

For starters, governments could use an earnings rate that reflects the market returns of the pension fund, with a cap, as Philadelphia Mayor Michael Nutter reportedly has proposed. Alternatively, you could pay an interest rate comparable to bank CDs that mature when the employee is first allowed to cash out. Then ask for a hard-nosed actuarial audit of the current scheme to see if it's really cost-neutral. If it's not, require the actuary to propose viable plan redesign changes. Finally, ask the broader question of whether the real problem lies in faulty core pension plan design that discourages sustained public service. Consider reforms of the entire plan, not just the DROP feature, to take into account today's longevity and the illogic of retaining workers at unnecessary expense because the basic pension formula is outdated, excessive and illogical.

In fairness, there are also well-designed pension plans with rational DROP features. But the burden now falls on the remaining plan sponsors, unions and pension trustees to prove that there is not a better way to retain and reward genuine public servants for a full career.

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