Deferred Retirement Option Plan (DROP)

A deferred retirement option plan, almost always shortened to DROP, is a feature written into a governmental defined benefit plan under which an employee who has already qualified to retire elects to keep working while their retirement benefit is treated as though it had begun. The IRS describes the typical design in its own manual: a participant who is eligible to retire and immediately receive payments "continues to work and makes an election to freeze their benefit accruals (no additional service or compensation credits accrue)," and "the amounts that the participant would have received as a DB retirement payment had he retired are credited to the DROP."

Two things are worth getting straight at the outset. First, a DROP is a feature of a pension, not a plan in its own right, so there is no such thing as opening one independently. Second, the noun varies: the IRS says "Plan," while several state systems, Florida's among them, call the same thing a Deferred Retirement Option Program. They describe the same arrangement, and which word a reader meets depends only on which system wrote the document in front of them.

The mechanics rest on a legal fiction that is easy to state and easy to misread. For the purpose of calculating the benefit, the participant is retired. For every other purpose, including their paycheck, their job, and usually their health coverage, they are still an employee. So the pension formula stops running: no further years of service, no further salary increases, no further credits. Whatever the formula produced on the day of entry is the monthly amount for life, subject only to whatever cost-of-living adjustment the plan provides.

What accumulates, and under whose rules. The IRS distinguishes two money flows into a DROP. The first is the stream of monthly payments the participant would have received had they actually retired, which the manual calls DB Benefit Amounts. The second is any further employee or employer contribution the plan chooses to allow, which the manual calls Additional Contributions. Some plans credit interest on the balance, some do not, and the rate is whatever the plan document says. The IRS is explicit that the crediting cannot be left open: "the benefits can't be subject to the employer's discretion. The plan document must be clear as to what rate of return, if any, is credited to the DROP." Because these plans are creatures of individual state and local statutes rather than of a single federal scheme, there is no national answer to how long a DROP period runs, what it pays, or who may enter one.

A back DROP reaches into the past instead of the future. The IRS defines it plainly: "a back DROP is a plan into which contributions to the DROP account are made for the years after the employee enters into the arrangement and for prior years. The plan determines the specific years." In practice a back DROP lets someone who kept working past their retirement eligibility elect, at separation, to have the arrangement treated as though it had started earlier, producing an immediate balance and a pension calculated as of that earlier date. It is the same trade compressed into one decision.

The federal tax envelope is narrow and mostly favorable. A public pension is a governmental plan as defined in Internal Revenue Code section 414(d), and governmental plans are exempt from several of the qualification requirements that bind private ones. On the specific question a DROP raises, the IRS says that "DB Benefit Amounts credited to a DROP aren't treated as annual additions subject to the IRC 415(c) limitation," so the pension payments diverted into the account do not consume the annual contribution ceiling that applies to defined contribution accounts. Additional Contributions are also outside that limit unless the DROP has segregated accounts for each participant, credits earnings based solely on actual investment results with no fixed or guaranteed rate, and never stops the accrual of earnings. Where all three are true the account looks enough like a defined contribution account that the annual additions rules attach.

The decision is arithmetic, and the plan has to supply the inputs. A DROP converts future pension growth into a present balance. Whether that is worth doing turns on how much the formula would still have added, what the plan credits on the balance, how long the participant expects to draw the pension, and what the plan's survivor and cost-of-living terms look like on each side of the choice. Two features make the comparison harder than it looks: the frozen benefit is frozen for life, including for any survivor annuity computed from it, and the DROP balance is a fixed sum that has to last, while the pension it replaced would have continued regardless of how long the retiree lived.

1. Qualify and elect. The participant must already be eligible to retire and immediately receive payments under the pension. Entry is an election, made under the plan's own rules, and is often irrevocable.

2. The benefit is calculated and frozen. The plan runs its formula as of the entry date. That figure becomes the monthly pension, and no further service or salary changes it.

3. The pension is credited to the account rather than paid. Each month the amount the participant would have received goes into the DROP, along with any additional contributions and any interest the plan credits.

4. Employment continues normally. Salary, duties, and usually health coverage are unaffected. Some plans continue to take employee contributions; some stop them.

5. Separation triggers the payout. When the participant actually leaves, the pension begins in cash at the frozen amount and the accumulated balance is distributed under the plan's terms, commonly as a lump sum, an annuity, or a rollover to another eligible retirement plan or an individual retirement arrangement.

A hypothetical, and the arithmetic is the whole decision. Marcus is eligible to retire with a pension of $4,200 a month. His plan offers a three-year DROP. If he enters it, the pension freezes at $4,200 and that amount is credited to the account for 36 months, so the account receives 4,200 × 36 = $151,200 before any interest the plan may credit.

If instead he keeps working for those three years without entering the DROP, three more years of service and a higher final average salary would have taken his pension to $4,900 a month. So the choice is a balance of at least $151,200 against $700 a month more for life. Ignoring interest, taxes, and any cost-of-living adjustment, the pension difference recovers the balance in 151,200 ÷ 700 = 216 months, or 18 years. A participant who expects to outlive that by a wide margin is giving up real money; one who does not, or who has a specific use for a lump sum, may be doing the opposite. The figures are illustrative; only the plan's own numbers answer the question.

Pros

• Produces a substantial lump sum without requiring the employee to save separately for it, and without stopping their salary.
• The employee keeps working, so pay, seniority, and usually employer health coverage continue during the DROP period.
• Payments diverted into the account are not annual additions under the section 415(c) limit, so the arrangement does not consume the ceiling that caps contributions to the employer's defined contribution plans.
• For an employer, it retains experienced staff who were already free to leave, which is generally the reason these features exist.

Cons

• The pension is frozen permanently. Years worked during the DROP add nothing to it, and neither do raises.
• A survivor annuity computed from the frozen benefit is smaller for the same reason, which affects a spouse long after the participant's decision.
• The interest credited on the balance is whatever the plan says, which may be well below what the forgone pension growth was worth.
• Entry is often irrevocable and the DROP period is fixed, so someone who wants to keep working past the end of the window can face a hard deadline to separate.
• A lump sum carries longevity and investment risk that a lifetime pension does not, and the tax treatment of the distribution depends on how it is taken.