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Authorize Optional Lump-Sum Retirement Payments

Allow members of the Teacher Retirement System and Employees Retirement System to elect partial lump-sum retirement payments.

Deferred Retirement Option Plans (DROP) are optional payment systems that allow participating retirement plan members to elect to receive a single lump-sum payment in exchange for a reduced monthly benefit for life. In essence, the participant receives a large check at retirement in exchange for a smaller monthly annuity payment.

The 1997 Legislature adopted a DROP for members of the Teacher Retirement System (TRS), effective September 1, 1997. House Bill 2644 established the DROP, which allows active members to accumulate funds in a special account to be disbursed upon retirement in addition to other retirement benefits. The Employees Retirement System of Texas (ERS) does not have a DROP.

DROPs add flexibility to pension plans and are intended to be cost-neutral to the state. DROPs were introduced in Louisiana in the mid-1980s in several firefighter plans. The most common DROP, known as a "regular" or "forward" DROP, allows members who are eligible for retirement to sign a binding agreement to leave employment after completing an additional period of service--usually two to three years, but in some cases as long as five years.

At the end of the DROP period, the member receives monthly benefits based on age, salary, years of service, and the plan formula in effect on the date of entry into the DROP. In addition, the member receives a lump-sum payment equal to his or her monthly benefits, with interest, accumulated from the date of entry into the DROP until the actual retirement date. The lump-sum payments are subject to federal withholding requirements. To ease the tax burden on plan participants, however, some DROP plans allow the lump sum to be paid over a period of time.

In the United States, DROP plans are more common among municipal fire and police retirement systems than in state retirement systems. This is primarily because municipalities want to offer retirement plan options to keep experienced employees in critical functions for as long as possible. DROPs can, in effect, achieve the opposite goal of early retirement incentives, which encourage employees to retire so that organizations can eliminate positions and reduce costs. Moreover, retirement benefits usually are more generous in fire and police plans because many members do not participate in the federal Social Security program. Many of these plans, for example, have 3 percent retirement multipliers for each year of service and "20 and out" features, as in the military, that allow members with 20 years of service to retire at any age.[1]

DROPs are intended to allow employers to offer flexible benefits to their members at no additional cost. However, once participation in the DROP begins, the decision to participate is irrevocable. Salary adjustments received while participating in a DROP do not affect retirement benefits. Furthermore, DROP participants are not eligible for cost-of-living adjustments granted to retirees either during DROP participation or in any period of continued employment after DROP participation. DROPs can be complicated to administer, depending on how they are structured.

Teacher Retirement System DROP
To participate in its DROP, TRS members must contribute to the system, be eligible to retire with a standard retirement annuity, and have at least 25 years of creditable service. The program was designed to allow active members who meet these criteria to continue to work and accumulate funds to withdraw in a lump sum or on a timed payout. Members have a one-time election to participate in the DROP, which is irrevocable.

The DROP participation period may range from one to five years in one-year increments. The amount of a member's standard retirement annuity is calculated as of the date of participation in DROP. A DROP account is established for each participating member. Each month, 79 percent of the calculated standard retirement annuity is deposited into the DROP account. The balance in the DROP account, plus 5 percent annual interest, is distributed upon retirement. State and member contributions continue to be made during DROP participation. DROP participation can be terminated only by death, retirement, or expiration of the DROP participation period.[2]

As of February 18, 1998, 600 TRS members were in the DROP system and another 916 applications were scheduled for processing. About 3,500 members have expressed serious interest in establishing DROP accounts since the program was established on September 1, 1997.[3]

Louisiana's alternative to DROP
The Teacher Retirement System of Louisiana (TRSL) has a program called "Option 5" as an alternative to its regular DROP. In Option 5, retirees may choose to receive a lump-sum payment not to exceed 36 months of their maximum retirement benefit at the time of retirement and to receive reduced monthly benefits thereafter. This option can be chosen as an "immediate" DROP; in other words, a member's decision to take a lump-sum distribution can be made upon, rather than before, retirement. This option does not involve a DROP period or DROP account, since the lump-sum payment is made upon retirement; thus, this program is much easier to administer than a regular or "forward" DROP.

Under Louisiana's program, for example, a 60-year old member with an annual retirement benefit of $24,000 who elects to receive a 12-month lump-sum payment upon retirement ($24,000) would receive 90 percent of his or her monthly standard annuity for life; the same person choosing a 36-month lump-sum payment ($72,000) would receive only 70 percent of the monthly standard annuity for life.[4]

According to TRSL, participation in Option 5 is low, primarily because of the popularity of its regular DROP program. Members participating in Louisiana's regular DROP are not eligible to participate in Option 5. Each year, about 2,000 eligible retirees select the regular DROP and continue working for the state; an additional 1,800 people actually retire. Of these, about 200 or 11 percent of the retiring members select Option 5 each year.[5]

The only complaints heard about the Option 5 program concern slow payments. People who withdraw large amounts--more than 85 percent of the maximum possible lump-sum payment--must wait until their final retirement benefit is determined before a check is issued. This can take up to six months. On average, however, retirees get their lump-sum payments in about two months.[6]

Members participating in Option 5 have several choices regarding the distribution of the lump-sum payment. They may receive the entire amount, less 20 percent federal income tax withholding, or they may roll over the entire amount to another qualified plan, such as an individual retirement account or 401(k) account. Members also may keep the money in an interest-bearing account at the retirement system and make monthly or yearly withdrawals that are subject to federal income tax withholding.

Texas Municipal Retirement System
The 1997 Legislature authorized a partial lump-sum distribution option for members of the Texas Municipal Retirement System (TMRS). A statewide system, TMRS administers retirement benefits for employees of Texas cities that voluntarily elect to participate in the system. As of March 31, 1998, 706 cities were participating in the system, which had a total of more than 89,000 members.[7] Each city plan is separately funded by employee and employer contributions.

TMRS' program is a form of "immediate" DROP, in which members can upon retirement elect to receive 12, 24, or 36 months of annuity payments immediately in exchange for a reduced monthly annuity. The lump-sum payment is deducted from the amount used to calculate the retiree's monthly annuity and a new, reduced monthly annuity is determined. The lump-sum distribution is made as a single payment at the same time as the first monthly annuity payment. The maximum lump-sum payment cannot exceed one-half of the member's total contributions and interest earnings.

The program has been quite popular with TMRS retirees. From the program's inception on September 1, 1997 to March 31, 1998, 387 out of 937 retiring members (41 percent) chose to receive a partial lump-sum distribution. Lump-sum payment amounts have ranged from $1,218 to $159,527.[8]

TMRS has prepared sample reports to determine how much retirees' standard monthly benefits would be reduced if they elect partial lump-sum payments. According to one of these samples, a retiree with more than 27 years of service who elects a 12-month lump-sum payment of $15,000 upon retirement would receive 92 percent of his or her monthly standard annuity for life; the same retiree choosing a 24-month lump-sum payment of $30,000 would receive 84 percent of the monthly standard annuity for life.[9]

The state should implement retirement options for the Employees Retirement System (ERS) and Teacher Retirement System (TRS) to allow retiring members upon retirement to elect to receive an immediate Deferred Retirement Option Plan (DROP) in exchange for a reduced lifetime monthly annuity.

This would be an entirely new option for ERS members and would be a second form of Deferred Retirement Option Plan (DROP) option for TRS members. TRS members participating in the regular DROP program would not be eligible to participate in this option.

The plan should be similar to the Texas Municipal Retirement System's (TMRS) plan, in which retiring members may elect to receive 12, 24, or 36 months of a standard retirement annuity in a lump-sum payment in exchange for a reduced lifetime monthly annuity. This retirement option is similar to a regular DROP, but would be simpler to administer and easier for members to understand. Because there is no DROP period that requires members to continue working, this option would not encourage employees to do so; the decision to elect a lump-sum payment would be made only upon retirement.

Fiscal Impact
This recommendation would have no fiscal impact on the state retirement systems as the plan should be designed to be actuarially cost-neutral.

[1] Telephone interview with William S. (Shack) Nail, general counsel, Employees Retirement System of Texas, Austin, Texas, February 3, 1998.

[2] Teacher Retirement System of Texas, "Drop a Preview of the Deferred Retirement Option Plan," ( (Internet document.)

[3] Memorandum from Ronnie Jung, Teacher Retirement System of Texas, "Status Report on Deferred Retirement Option Plan (DROP)," February 18, 1998.

[4] Teachers' Retirement System of Louisiana, "Is Option 5 the Right Choice for You?," Baton Rouge, Louisiana, June 1996. (Pamphlet.)

[5] Telephone interview with Bonita B. Brown, assistant director, Teachers' Retirement System of Louisiana, Baton Rouge, Louisiana, May 21, 1998.

[6] Telephone interview with Bonita B. Brown, May 21, 1998.

[7] Texas Municipal Retirement System, e-mail from Pete Krnavek to Ray Spivey, June 2, 1998.

[8] Texas Municipal Retirement System, "TMRS Partial Lump Sum Distribution," Austin, Texas, May 26, 1998. (Summary.)

[9] Texas Municipal Retirement System, "Monthly Service Retirement Benefit Estimates," Austin, Texas, June 5, 1998, p. 3.