DROP plans are really hybrid pension plans – a cross between a traditional pension (defined benefit) and the newer defined contribution plans. In the end, you have both a lifetime pension and a lump sum rollover.
I'm not sure if many private pension plans have the DROP options, but there are many public sector plans: state, county, city and teacher pension plans, with DROP.
The DROP plan allows the employee to retire from the pension plan, cease participating as an active employee, but remain fully employed. During the years they are a DROP participant, the monthly pension amount is “deferred” into a DROP account in the participant's name.
The DROP participant does not gain in a higher pension benefit, the benefit and retirement options have been calculated and are fixed for life. They do start to accumulate a DROP account of the accumulated monthly pension payments being paid into DROP.
The plan can administer the DROP policy in many different ways. They can calculate the full pension that goes into the DROP account, or they can choose to DROP a percentage of that pension (for example, 80%). They can pay interest, or not. Normally, there is a maximum time limit that an employee can remain in DROP – that doesn't mean they must retire, but it does mean that the DROP payments might end.
When the participant chooses to retire, the employer pays out the monthly pension, like they would with any other retiree. They also do a plan to plan transfer or payout of the DROP account to any IRA that the participant chooses.
A public employer cannot allow an employee to "double dip", receiving both pay and a pension from the same public employer.
However, with the DROP plan, the pension is not “paid” to the employee. DROP Payments are paid into a DROP fund and held until the participant terminates employment. At that time, no longer employed, they funds are transferred to another retirement fund (like an IRA).
Employer: The employer wins as they can keep long term employees, a bit longer, without losing them to retirement. This strategy was born because employers feared losing all the Boomer employees. Employers were told they'd lose all the long-term knowledge of boomers, and possibly there weren't enough of the next generation to carry on. They needed more time to reinvent and train the next generation.
They also have all the newly generated DROP funds earning interest in various investments. That builds up the system, assuming a good market, even if they only have the funds on hand for a few years.
Employee: For boomers, many of whom worked one employer for a lifetime, this was the perfect solution when they weren't quite ready to retire.
They had a pension, but often it was max'd out as they had worked 25+ years for the employer. At the time of DROP, they were required to lock their pension in. They chose the payment plan, the option of survivor benefits, and they know the pension is set for life. Now, they remained employed and were contributing, via the DROP, towards another retirement plan.
While the DROP participants remained employed, their employee benefit levels might change, depending on labor agreement changes as they remain an active employee. However, they had the same job and same income, as they were still employed. Plus, they are now contributing, via the DROP, towards another retirement plan.
There is no taxable event when the employee enters DROP -- as the funds went from employer retirement account to individual retirement savings account. However, when the funds are withdrawn, taxes are paid.
If you have any questions on DROP, as it is spelled out above, use the Contact Wendy page. I have been retired ten years now (2010-2020) so DROP plans may have evolved by now into new hybrid DROP plan but I will explain as much as I can.
Defined Benefit Plans (traditional pensions)
Defined Contribution Plans (newer savings plans)