How Deferred Retirement Option Plans Work

When planning for retirement, it helps to know all your options and weigh them carefully. You’ll also need to decide when you want to retire. Early retirement might be an option for you, depending on your financial situation. You might prefer to stay busy by working until a later age instead, however. It helps to know the benefits and drawbacks of each scenario and the timeline for your retirement. If you choose to work beyond the traditional retirement age, your employer may offer a DROP (Deferred Retirement Option Plan).

What Is a Deferred Retirement Option Plan?

How Deferred Retirement Option Plans Work

Image via Flickr by 401(K) 2013

A DROP is an option for an employee eligible for retirement who chooses to continue working. If you decide to keep working and participate in a DROP, this means your employer won’t continue adding new years of service to your pension fund. Traditionally, adding to your pension fund means that the amount of the pension they’ll be required to pay out to you when you finally retire will be higher.

In exchange for adding to your fund, your employer will open an interest-bearing account for you, and they’ll start to place lump sums into your DROP account. At the time of your retirement, you’ll receive the entire value of the DROP account, along with your previously established pension benefits. The advantage of a DROP is that you can start earning retirement benefits while your employer benefits from your services.

Most DROPs are for public sector employees, such as teachers, firefighters, and police officers. These plans were initially introduced to workers employed by the government, and pension plans are seldom offered in private companies anymore. DROP is specifically applied to an employee with a defined benefits retirement plan provided by their employer. This defined benefits retirement plan is usually in the form of a fixed pension.

How Are DROP Benefits Calculated?

The specifics of a DROP can differ, as many different employers offer them. However, there are some common factors to be aware of when considering using a DROP.

  • Participation length: Term limits are part of all DROPs. Employers won’t allow you to participate indefinitely. Instead, there’s a window of time termed a participation limit. Some plans will allow you to participate for a maximum of seven years, but employers set a limit of four years for employee participation in many cities.
  • Payment amount and interest: Your employer will specify the dollar amount they’ll pay into your DROP account. They’ll lay out how it’ll gain interest and how much interest your funds will accrue. In most cases, your DROP payments will equal the retirement benefits you would typically receive during the same period. However, this isn’t the case in every plan, so you’ll need to check with your employer for your DROP’s specifics.
  • Health, worker’s compensation, disability, and other benefits: Some DROPs may classify you as formally retired even though you’re still working. If this designation applies, you may lose some of your previous employment benefits. So, while you’re weighing the possibility of participating in a DROP, make sure to check how your other benefits will be affected. Once you’re officially retired, these protections usually end.
  • Dispersal and Taxes: Once you’re no longer working for your employer at all, and hence fully retired, you’ll be paid the full value of your DROP account, but your employer may have different specifics for how the funds are paid out to you. Some DROP plans will pay you in one lump sum upon formal retirement. Others may offer to pay you over time. It’s essential to investigate what these differences mean for your tax situation upon reaching your retirement.

A DROP may feel daunting to figure out and complex to calculate, but they’re more straightforward than they may seem at first. For example, imagine you’re a teacher retiring after 30 years on the job, your average salary was $55,000, and your employer offers you a DROP plan with a four-year participation limit and an accrual rate of 2%. Multiply your average salary by the accrual rate, then multiply that by the number of years worked. Finally, spread that over the participation limit to find your DROP account worth.

In this example, your DROP would be 55,000 x .02 x 30 x 4 = $132,000.

DROP Pros and Cons for Employers and Employees

The primary benefit of a DROP for the employer is that they have you on the job longer. Keeping you in your current position longer helps keep the workforce stable, especially in educational and law enforcement fields. There are also benefits of DROPs for you. Let’s explore some of the pros and cons of a DROP for employees.

Pros for Employees

  • You can continue to work at a job you enjoy past the traditional age of retirement.
  • You’ll continue to add to your retirement savings, especially after you may have already maxed out your lifetime pension benefits.
  • You may receive a higher accrual rate than your defined-benefit plan would have provided you.

Cons for Employees

  • A DROP may have a short enrollment window, so you can easily miss the period when you can enroll. To prevent this, make sure you get all the details from whoever handles retirement planning for your company, which is typically the Human Resources (HR) department. Keep abreast of the pertinent dates for enrollment, so you don’t miss out.
  • Taking a lump sum payment of your DROP can push you into a higher tax bracket that year. To guard against that, see if your employer has another payout structure available, such as dispersing the DROP account dividends over time.

For assistance with understanding your options regarding DROP, traditional retirement plans, fixed pension, and other retirement investment opportunities, please don’t hesitate to contact 3D Wealth Advisors. 3D partners boast over a decade of experience helping Hawaii residents and travelers manage their finances, taxes, retirement planning, and investments. Put us to work for you and build a financial legacy to support you through your retirement years. We can help you weigh all your options to bring you peace of mind and help you enjoy the retirement you’ve worked so hard to achieve.