How Does a Deferred Retirement Option Plan (DROP) Work?

For many people, retiring in one swift, all-or-nothing move can be harder than it sounds. Many people struggle with the transition itself, not going into work anymore, not seeing the colleagues they have spent years alongside, and not feeling as productive as they once were can take a real toll on their mental and physical health. That's why so many people choose to retire in name but keep working in some capacity, just to stay engaged.

But if you do choose this route, what actually happens to your retirement savings in the meantime? If you are still earning an income, you may want to consider deferring your payouts rather than claiming them right away. This is exactly where a Deferred Retirement Option Plan comes in. Let's take a closer look at what it actually offers.

What is a deferred retirement option plan?

A Deferred Retirement Option Plan, commonly known as a DROP retirement plan, is a special type of retirement plan. Anyone can use it, but it is usually offered only to civil servants and Tier 1 public safety members. These may include police officers, firefighters, teachers, local government employees, etc.   

Here's the basic idea behind how it works:  

Once an employee becomes eligible to retire under a defined benefit pension plan, a Deferred Retirement Option Plan gives them a straight option. Instead of retiring right away, they can choose to keep working while officially electing to participate in the Deferred Retirement Option Plan program. The key point to note here is that continuing to work under this arrangement does not add any additional years of service that would otherwise increase your pension calculation. Essentially, it lets you stay on the job and keep earning a paycheck without your pension growing the way it normally would through added years of service.

The deferred retirement plan rules are quite clear and straightforward.  

When an employee enters the Deferred Retirement Option Plan program, their pension benefit is calculated based on their service history and pay at that time. This locks in that calculation from the moment they enter the plan. For the duration of the Deferred Retirement Option Plan, a percentage of that pension benefit is credited to the employee's Deferred Retirement Option account. Meanwhile, the employee continues working as an active member of the organization, as they otherwise would.

While employees continue working under the Deferred Retirement Option Plan, their employer deposits a lump sum into an interest-bearing account on their behalf each year they remain employed past their pension eligibility date. This account continues to accumulate over time and may grow each year the employee chooses to stay on. When the employee eventually retires, they generally choose how to receive the accumulated money. They can take the full amount sitting in the deposit account as a single lump-sum payment, or alternatively, roll it over into a deferred compensation account or another qualified retirement plan, depending on what works best for them at the time.

Under the deferred retirement plan rules, once the period comes to an end and the employee officially retires, they receive two things:  

• A lump-sum payment equal to whatever has accumulated in their account, including interest earned along the way
• A lifetime pension benefit

This lifetime pension benefit is based on what the employee had already accrued as of the date they entered the Deferred Retirement Option Plan program, not on any additional time worked between entering the plan and leaving their job.  

Several factors determine how much you end up receiving deferred retirement benefits through a Deferred Retirement Option Plan arrangement. The first factor is the interest rate your employer pays on the funds accumulating in your Deferred Retirement Option Plan account. Your plan specifies this rate directly. The second factor is how long you choose to participate in the program. Most employers cap this participation period, which varies by employer plan. The third factor is the accrual rate.  

Here's an example of how the DROP retirement plan works

Imagine a retirement plan that calculates the annual pension as 2% of a member's final salary, multiplied by their total years of service. Consider an employee who has put in 30 years on the job and earns $60,000 annually. Their pension would be calculated as follows:

2% × $60,000 × 30 years = $36,000 per year

If this member chooses to enter the DROP program and continues working for another three years, their total time on the job becomes 30 + 3 = 33 years. Once the three years are up and the member officially retires, they will start collecting the same $36,000 annual pension calculated earlier. On top of that, they will get a one-time payout equal to whatever accumulated in their DROP retirement plan during those three years:  

$36,000 × 3 years = $108,000 lump sum

The bottom line is that the employee will get a $108,000 upfront payment plus $36,000 coming in every year afterward.

Pros and cons of using a Deferred Retirement Option Plan

Before you choose this option, you must understand in detail what you stand to gain and potentially lose. A Deferred Retirement Option Plan can affect both employees and employers. Let's understand these:

Pros of using a DROP retirement plan

1. It simplifies workforce planning for employers

From an employer's perspective, this arrangement can be appealing because it simplifies workforce planning. When an employee enters a Deferred Retirement Option Plan, they indirectly signal when they are likely to retire. This gives you enough time to find a replacement and ensures the organization's operations are not interrupted.  

2. You can keep working while your pension grows separately

For employees, one of the biggest draws is the ability to keep working and earning a regular paycheck while the employer deposits pension contributions into a separate, interest-bearing account on their behalf. In a sense, it lets you have it both ways for a while - a regular income now and deferred retirement benefits later on.  

3. Some plans allow tax-deferred rollovers

Depending on how your specific plan works, you may not have to take that final payout as a single lump-sum check. Many plans let you shift the money into accounts like the traditional Individual Retirement Account (IRA) or another employer-sponsored retirement account instead. By doing this, you don't have to pay tax until you start withdrawing money, rather than in the year you receive it.  

4. You can build up a substantial lump-sum payout

Because your pension money sits accumulating for years rather than being paid out to you right away, you can end up with a genuinely large lump sum. For someone who wants lump-sum funds, maybe to pay off a mortgage or help a kid through college, this option can hold real appeal.

Cons of using a DROP retirement plan

1. Your total benefit may not exceed what you would get otherwise

The total amount you ultimately receive through a Deferred Retirement Option Plan may be more or less similar to what you would have received had you simply retired outright and started claiming your pension immediately. This may not be the case every time, and the actual outcome can vary widely depending on your plan's structure. Nevertheless, this is something you should keep in mind.  

2. You could lose access to other employment benefits

Some plans may consider you retired the moment you enter the plan, even if you still show up every day. However, this classification can strip away some employment benefits, such as health insurance or disability coverage. Make sure you understand the deferred retirement plan rules before you enroll yourself.

3. Distributions may be taxable

Distributions from a Deferred Retirement Option Plan may be treated as taxable income once they are paid out, regardless of whether you receive the money as a lump sum or through structured installment payments. How your payout is timed and structured can affect your marginal tax rate in the year you receive the funds. Taking a large lump sum, for example, could push your taxable income higher in a single year, while spreading payments out through installments may help distribute that tax burden across multiple years instead.

4. Participation is limited to a set period of time

One last thing to keep in mind - Deferred Retirement Option Plans only allow you to participate for a limited, predetermined period of time. This is not a strategy you can rely on indefinitely. So, plan accordingly to ensure your retirement needs aren’t impacted.

Deferred Retirement Option Plan – Use it or DROP it?

So where does this leave you? A Deferred Retirement Option Plan can be a good option if you like the idea of letting your retirement savings build for a few more years before you fully step away from work. While the plan doesn't offer indefinite benefits, it can still come in handy for a few years. That said, this option isn't available to just anyone. You must be employed in the civil service or public sector to qualify.

You also need to keep an eye on the trade-offs. Getting classified as retired for the purposes of your plan could result in losing benefits you are currently relying on, such as disability coverage or health insurance.

Given how much of your future financial security is riding on this plan, enrolling in one is not a decision to make alone or on a whim. Sitting down with a financial advisor can help you weigh whether a Deferred Retirement Option Plan is right for you. If you don't already have an advisor you trust, our financial advisor directory can be a good place to start.  

Frequently Asked Questions (FAQs) about the Deferred Retirement Option Plan

1. Who can use a Deferred Retirement Option Plan?

This option is generally available for people who are already retired or approaching retirement. It is open to people within specific public-sector roles, such as law enforcement officers, firefighters, educators, Tier 1 public safety members, and other civil employees.  

In short, if you work in a pension-covered public-sector role, you can possibly use a DROP retirement plan. That said, always confirm with your specific employer.  

2. What is the difference between a DROP retirement plan and a defined benefit plan?

These two plans work quite differently. With a defined benefit plan, your pension amount is tied directly to how many years you have worked for your employer, so every additional year on the job can result in a higher pension. Once you hit retirement age, you can start collecting whatever you have accrued over time.

A Deferred Retirement Option Plan is a unique retirement account. If you keep working past your retirement date, your employer sets aside a lump sum into a separate, interest-bearing account on your behalf. The additional years of work do not count towards your pension calculation. However, your lump sum can earn interest and possibly grow over time.  

3. Who is eligible for a Deferred Retirement Option Plan?

The eligibility depends on the specific plan and the type of employee in question. That said, a few general requirements tend to hold true across the board.  

You need to be already part of a public service pension plan to qualify in the first place.

You may have to have worked for a certain duration, somewhere around 25 or 30 years, before you are allowed to enroll.  

Since these requirements can vary widely from one employer to the next, it’s best to check the specific details of your own employment and plan accordingly.