Deferred retirement option plans expose public pensions to unique risks

A range of states, from Arizona to Florida, are introducing proposals to extend or introduce a deferred retirement option plan (DROP) to help retain public employees, specifically public safety personnel. While it’s true that public safety vacancies are up, there is little, if any, evidence to suggest that increasing a public pension plan’s benefit offering will help retain workers. 

A deferred retirement option plan is a mechanism that allows a retirement-eligible member to begin receiving his or her pension benefit while still working. However, instead of this benefit being paid out like a typical pension, a DROP participant’s pension is placed into a separate account available for a lump-sum withdrawal when the member stops working for the employer. This separate account also earns interest, typically at the pension plan’s assumed rate of return. 

When looking into pension plans that offer a DROP, a clear trend emerges: poorly funded plans and a swamp of unfunded liabilities. The most extreme example is the Dallas Police and Fire Pension System. Dallas’ deferred retirement option plan single-handedly brought the pension system to its knees, with 56% of all assets in the system earmarked to pay for DROP withdrawals. As a result, the fund had relatively few other assets to invest, leaving it little option to take on longer-term and higher-yielding investments. The fund eventually had to stop DROP withdrawals altogether because it lacked the liquid assets needed to pay for the DROP benefits.

The actuarial standard of practice (ASOP) No. 51 addresses this type of cash flow risk. It warns that public pension plans thinking of offering a deferred retirement option plan while they are already struggling with unfunded liabilities could find DROP lump sum payments to be a particularly difficult issue.

A deferred retirement option plan changes the way a pension system can invest its assets. As more pension systems chase illiquid assets to hit lofty assumed rates of return, a DROP puts more pressure on liquidity needs. The rosy assumptions of many public pension systems, especially when looking at muted 10–to-15-year market outlooks, add more volatility and risk of underfunding if more assets must be held back to pay for large DROP lump-sums.

Accruing additional pension liability at a time when capital market assumptions aren’t in line with pension plans’ assumptions is a move that exposes public employers—and thus taxpayers—to more risk at a time when they should be seeking ways to reduce risk.

A deferred retirement option plan also adds further underfunding risk due to the way interest is paid into the members’ DROP accounts. Pension systems generally have a 30-year investment outlook, assuming that the good years and bad years will average out and get the plan to a certain investment percentage over the long run. This percentage is the plan’s assumed rate of return. Most pension systems that offer DROP options set the interest paid on a member’s DROP account at the plan’s assumed rate of return. If the plan misses its assumed rate of return over the period, it still must pay that higher guaranteed interest rate into the member’s DROP account. Thus, instead of having years to make up for these losses, those losses are compounded. 

Apart from the cash flow issues that deferred options introduce, a DROP also drastically changes the way a public pension plan must fund its benefits. Pension plans regularly run studies to align their assumptions with actual experience to ensure that they are neither underfunding nor overfunding the system. One of the most important assumptions a plan studies is the expected retirement age of its members.

For example, a pension plan may have a normal retirement age of 55, but research may show the average member actually retires around age 60. Therefore, the pension plan may fund benefits with the expectation that the average member will begin drawing his or her pension at age 60.

However, a deferred retirement option plan completely negates that funding design, as there is no reason for a member to not enter DROP at the earliest possible time he or she can. The pension plan must then revise downward its assumed retirement age, resulting in higher required contributions to keep the pension plan properly funded. This issue is exacerbated further for any pension system that offers an early-retirement option, especially for public safety plans specifically, due to their already lower retirement ages. 

A deferred retirement option plan does not solve the root cause of some agencies experiencing police officer retention problems. Employee engagement and recruitment surveys of law enforcement officers show they believe it is more difficult to be a police officer than it used to be. Pushes for criminal justice reform and transparency, changes in the public perception of police officers, rising violent crime rates in some areas, and other issues are all factors.  Throwing additional retirement benefits into the mix is unlikely to solve the retention problems governments are having with police, especially for already strained city, county, and state pension systems and budgets.

Other potential solutions like offering increased salaries or “retention bonuses” might more effectively address retention challenges, and if they don’t, at least they won’t do long-term harm to pension funds that millions of public workers across America are relying on.