DROP Plan Design and Investment Considerations David Kent, FSA, MAAA Ryan Miller, ASA, MAAA
Agenda History Features and Plan Design Considerations What Has Gone Right? What Has Gone Wrong? Investment Considerations Future of DROP 1
Historical Context Public safety plans have historically been designed with earlier retirement eligibility than that in other plans Necessary due to the type of work done The job is more physically, mentally, and emotionally demanding However, some employees are: Still capable and eager to work at the Plan s retirement age Have a financial incentive to retire, and get a job somewhere else Able to receive a pension and a paycheck at the same time 2
Historical Context DROP to the rescue! DROP = Deferred Retirement Option Plan DROP is a mechanism that allows members to receive their pension, and still continue working and receive a paycheck Employee stays active and continues to be paid Pension benefit is calculated at DROP date and paid into a nominal account, and accumulated until the employee retires Takes the financial incentive out of leaving employment as soon as members are eligible 3
Historical Context Should be a win/win Employees get to stay longer at a job they like Retain seniority Likely higher pay than starting out at a new place of employment Employers get to keep valued employees Retain experienced employees It is Cost Neutral Probably not, as we will see later, that really depends on the design 4
Features of DROP Active Population Considerations Limit on length of time in DROP Depends on how you much longer you want to encourage employees to work Should be determined in conjunction with employer Contributions Will they continue to be made? Will some portion be returned to employee or stay with the Plan? 5
Features of DROP Forward DROP or Retroactive DROP? Forward DROP Member elects DROP date, then continues to work until ultimate retirement date Retroactive DROP Member works until ultimate retirement date, then elects a DROP date in the past 6
Features of DROP Forward DROP or Retroactive DROP? As long as the plan features are the same, either option should generally create the same result However, members have the benefit of hindsight with Retro DROP Can time the DROP date to maximize benefit based on pay increases Often leads to longer employment 7
Features of DROP DROP account payment at retirement Immediate payout Allow the member to leave the account with the plan for some period of time Members often like this idea Defers taxes May receive the benefit of interest rate guarantee 8
Features of DROP DROP account payment at retirement Problem is that DROP is not a savings account It is a mechanism to allow members to receive a pension and a paycheck Using DROP for something it is not designed to do can lead to trouble 9
Features of DROP Interest credited to DROP account Will interest be credited to the DROP account while with the plan? DROP is attempting to replicate what happens when a member retires and gets another job In that situation, a member could live on their salary, and save their pension in an interest bearing account Truly cost neutral plan would credit actual interest earned by underlying plan assets Tough to do since the DROP accounts are nominal Some issues with granting interest less than zero 10
Features of DROP Interest credited to DROP account Crediting something related to the long term asset return assumption seems reasonable at first However, doesn t account for volatility Or changing economic environments 11
Features of DROP Interest credited to DROP account Some plans have a desire to guarantee a minimum rate to the DROP accounts Since the underlying assets have no such guarantee, this will lead to losses The plan design needs to take this into account Fund for this extra benefit Hard to do as DROP accounts become a larger portion of the assets Design the plan so that the losses due to the guarantee are made up for in other years (i.e. make it cost neutral again) 12
Features of DROP Interest credited to DROP account The interest rate credited to DROP accounts can be the biggest generator of gains or losses Should be subjected to rigorous stress testing in order to determine sustainability Remember, allowing members to earn a paycheck at a job they enjoy while simultaneously receiving a pension is a powerful wealth building tool Interest does not need to be granted for a DROP to do it s job of employee retention 13
What Has Gone Right? Plan Participants Employees who have the ability to enter DROP are working beyond the Plan s normal retirement age Regardless of other design features, the presence of a DROP has led to increased employee retention Employees are given the opportunity to retire with savings that they may not have otherwise been able to accumulate 14
What Has Gone Right? Plan Design Depending on the plan design Employers know how much longer in the future employees will work, and can plan accordingly If there is a limit on time in DROP and not retroactive Has increased funding in cases where: Contributions stay with the fund The rate credited to the DROP accounts is favorable to the plan Leads to later retirement, which can produce actuarial gains 15
What Has Gone Wrong? No limit on time in DROP Employees staying longer than desired Can create large DROP accounts which can lead to IRS 415 issues DROP account distributions are subject to 415 limit, but IRS rules are not clear on how to address the issue 16
What Has Gone Wrong? Members allowed to keep DROP accounts with Plan after retirement Usually only an issue do to high interest crediting rate to DROP account Can have 415 issues as DROP accounts grow with interest DROP is not a tax deferred savings plan with a guaranteed interest rate It is sometimes sold that way If the plan design allows, members will use it that way 17
What Has Gone Wrong? Members allowed to keep DROP accounts with Plan after retirement DROP accounts become a significant portion of the assets How much is too much? Liquidity issues can arise Can you pay out the retiree DROP accounts easily with little lead time? How comfortable are you guaranteeing the DROP crediting rate to that portion of your assets? 18
What Has Gone Wrong? Interest Crediting Rate Rates that were thought to be cost neutral decades ago have turned out not to be so When a higher rate is credited to the DROP accounts than is earned on Plan assets, assets that were intended to pay for non-drop pension benefits must be used to cover the interest This shifting of assets occurs at a particularly bad time, since it happens when the Plan is experiencing poor asset performance 19
What Has Gone Wrong? Interest Crediting Rate This loss may not be an issue if the DROP accounts are a small portion of total Plan assets However, if DROP accounts are a significant portion of plan assets, these losses can significantly impact the funding of the Plan 20
Investment Considerations Analysis Vary Plan DROP Crediting Rate Vary Plan Funded Status Plan Asset Allocation Expected Return over 20 years of 7.50% 21
Investment Considerations Potential Crediting Rates Adjusted Return on Market Value of Assets Market Return less 0%, 2%, 3%, 4%, 5% Floor equal to the expected return on assets (valuation discount rate) Constant Crediting Rates of 0.0%, 5.0%, 7.5%, 7.9%, 8.0% Other Rates Adjusted Average Return on Market Value of Assets DROP Account credited with an Index 22
Investment Considerations Cumulative Gains/(Losses) Due to the floor of 7.5%, the Adjusted Market Value Return credited to DROP creates losses to the Plan Losses reduce Plan Funded Status and increase contributions Constant crediting rates can produce gains, losses, and can be determined to be Cost Neutral at the median or a given percentile 23
Investment Considerations Percentage of Assets held in DROP Account At lower Plan Funded Status levels, the DROP Account becomes a larger portion of the Plan assets Due to leverage, if the DROP Accounts are withdrawn the Plan s Funded Status can be severely reduced 24
Investment Considerations Overall Plan Funded Status Overall the Plan Funded Status is similar between the Adjusted Market Value Return and the Cost Neutral Crediting Rate However, contributions to the Plan will be lower in the Cost Neutral case 25
Investment Considerations Plan Funded Status assuming DROP Withdrawn In cases with a low Plan Funded Status: DROP Accounts comprise a larger portion of the Assets There is an immediate drop in the Plan Funded Status Plan could become insolvent 26
Investment Considerations Plan Funded Status assuming DROP Withdrawn In cases with a low Plan Funded Status and poorer economic conditions: Plans could become insolvent sooner in the future A Cost Neutral crediting rate will not offset the poorer economic conditions 27
Investment Considerations Summary Plan s should consider: The impact the DROP Account could have on Funded Status and Solvency Not just the overall Funded Status of the Plan, but also stress test the DROP withdrawal assumptions Viewing the DROP Account assets separate from the overall Plan Assets DROP can be sustained or implemented when designed with crediting rates which can remain Cost Neutral even through poorer economic environments 28
Future of DROP DROP is a mechanism that allows members to receive their pension, and still continue working and receive a paycheck DROP does exactly what it is supposed to do It is a proven tool in employee retention It is a valuable wealth generator for employees DROP runs into problems when the design allows (or encourages) members to use it otherwise 29