STUMP » Articles » Hindsight is Hilarious: Pension DROP Program Presentation » 21 December 2018, 16:30

Just an FYI — for the holidays, I’m going through my posts-in-draft and see what I can easily finish up.

Thanks to a reader who provided me a link to this presentation on DROP benefits.

Because it’s funny… if you like your humor very dark.

(and I do).

The date on this presentation seems to have been June 2009, so one thing we must note: they don’t have the excuse of not knowing about huge market drops. They knew it had happened, and that it obviously was going to affect public pension funds.

WHAT IS DROP?

DROP stands for Deferred Retirement Option Programs.

The concept is fairly simple:

An employee who would otherwise be eligible to retire and start drawing down benefits from an employer’s defined-benefit plan keeps working instead. Rather than having those additional years of service included in future benefit calculations, the employer places a lump sum of money into a separate account for each year the employee remains on the job. This account would earn interest as long as you’re still reporting to work. Once you actually retire, the money held in that account would be paid to you, interest included, on top of whatever money you’ve accumulated in your pension plan over the course of your career.

So the concept is that a person will get both a lump sum amount and a stream of benefits at retirement. It can be a very sweet benefit, depending on eligibility age, crediting assumptions, etc.

THE PUNCHLINE: DALLAS

This is where I cracked up.

Because, of course, Dallas’s DROP program caused a bunch of its problems.

To many in Dallas, the hole in the pension fund seems to have blown open overnight. But in fact, the fuse was lit back in 1993, when state lawmakers sweetened police and firefighter pensions beyond the wildest dreams of the typical Dallas resident. They added individual savings accounts, paying 8.5 percent interest per year, when workers reached the normal retirement age, then 50. The goal was to keep seasoned veterans on the force longer.

Guaranteed 8.5 percent interest, on tap indefinitely for thousands of people, would of course cost a fortune. But state lawmakers made it look “cost neutral,” records show, by fixing Dallas’s annual pension contributions at 36 percent of the police and firefighters’ payroll. It would all work as long as the payroll grew by 5 percent every year — which it did not — and if the pension fund earned 9 percent annually on its investments.

Buck Consultants, the plan’s actuarial firm, warned that those assumptions were shaky, and that the changes did not comply with the rules of the state Pension Review Board.

This presentation was given in 2009, right after a big market value drop.

Oh look, Dallas Police and Fire was at the “healthy” 80% funded ratio for FYs 2008/2009, etc.

Now, that was from a blog post in 2016.

Would you like to see what it looks like with 2 more years of data?

Funded ratio is at about 50% for FY 2016.

Perhaps there is a good DROP story out there… somewhere…. but Dallas wasn’t it. And they should’ve known in 2009 that there would be trouble ahead.

WHAT THEY GOT RIGHT

The presentation is not all bad. It does get into details of what can go wrong in DROP benefits.

The Mary Williams Walsh article being quoted is this one: Cities Enriched Pensions, but Now Struggle to Pay — that’s from MAY 2004.

Some bits:

A few years ago, the city of Houston decided to sweeten its workers’ retirement benefits. Along with their traditional pensions, city workers nearing retirement were offered special accounts, fed with money from the city pension fund. Although the accounts would pay generous returns, a study showed that the cost to the city would be modest.

What seemed a good idea then now looks ruinous. Hundreds of older workers will qualify for million-dollar payouts at retirement from these accounts. When their monthly pension checks start coming, some will actually have higher incomes than they did when they were working.

The city pension fund cannot support the payouts and has about $1.5 billion less than the benefits it owes the work force. The district attorney is looking into possible wrongdoing. City voters will go to the polls on May 15 to decide whether Houston should opt out of a Texas constitutional requirement that all pension promises be kept.
…..
At the heart of the matter is a type of pension benefit that has generally been shunned by corporations but embraced by state and local governments. Known as a DROP, for deferred retirement option program, the strategy has been hailed as a way to keep hard-to-replace teachers, engineers and other public workers on the job as they near retirement.

Advocates say the plans allow workers to get big one-time checks when they retire, at potentially no additional cost. In practical terms, though, DROP’s have been abused again and again by naïve or self-interested officials, who have pumped up benefits well beyond what the rank and file expected or what the pension fund could pay. Records show that some of these officials set up rich programs to coincide with their own retirements.
…..
In 2002, the money-management and record-keeping firms that sponsor Guns and Hoses, a yearly party for fire and police pension officials, urged delegates to send in the details of their escrow accounts, for compilation in a catalog. Every delegate got a copy to take home, for use in negotiating better benefits. The sponsors got the data.

Speakers at these pension conferences usually state that the accounts can be ‘‘cost neutral,’‘ but warn local officials not to sweeten the benefits too much.

But when stock prices were booming, that caveat did not always register. Many pension officials assumed they could pack their programs with extras, and if it all cost too much, investment returns would make up the difference. Only later, when markets soured, did the magnitude of what they had promised become apparent.

Again, in 2009, there should have been signs. They cover Milwaukee:

Houston and San Diego:

WHAT IS REALLY WRONG: COST NEUTRALITY

The problem is that these DROP benefits are generally sold as “cost neutral” – a.k.a., this really shouldn’t mean the pension fund will have to increase contributions to cover these benefits.

I want to address that last line…

Because, it may be difficult to see if the benefit was cost neutral…. but it can be done. Because here is a recent report on the Los Angeles DROP program:

Is the DROP cost neutral?

The DROP is expected to be cost neutral under the prospective analysis, if members are retiring later than they would have without the DROP.

The DROP was determined to have been cost neutral under the retrospective analysis with assumed salary increases.

The DROP was determined not to have been cost neutral under the retrospective analysis with actual salary increases.

You can read the whole report if you wish, but let’s just ignore the prospective analysis, and the “well, if y’all had raised salaries as expected it would have been okay…” because that “what if” doesn’t really matter.

What actually happened?

An important factor in this retrospective analysis is that, as a result of the 2008 recession and
other budgetary constraints, the actual salary increases granted to active members as observed in
the ongoing actuarial valuations for several years after the 2008 recession (2009 – 2016) were
mostly less than projected by the actuarial assumptions. Forgoing benefit increases due to any
possible future salary increase is an important DROP plan design to help maintain cost neutrality
of the DROP. For that reason, we have applied the “retrospective” analysis for members who
actually signed up for the DROP using two alternative scenarios for salary increases without the
DROP.

The assumed salary increases scenario uses assumptions consistent with those applied in the
June 30, 2017 valuation to project salaries for the members from their date of DROP entry to
their assumed retirement date, which for this study is between one and three years earlier than if
the DROP were not in place. Under this scenario, our analysis shows there would be an increase
in the adjusted present value of benefits of less than 2% as a result of the DROP.
However, under the alternative scenario using the actual salary increases granted for the
members from their date of DROP entry to their assumed retirement date, which again is
between one and three years earlier than if the DROP were not in place, there would be an
increase in the adjusted present value of benefits of between 1% to 7% as a result of the DROP.

Now, this is not necessarily a huge difference.

BIG BENEFITS AND EXTRA COSTS

But there is another result of this DROP — some participants are getting benefits so large, Los Angeles has an additional tax penalty to pay: In Los Angeles, Massive Payments to Retirees Don’t Even Count as ‘Pensions’ Anymore

A heavily abused program breaks the limits of what the IRS allows, leaving taxpayers even further on the hook.

The Los Angeles Times reports that retirement pay for dozens of retired public officials has grown so large that they’re slamming into the ceiling of what the IRS allows to fall under the tax breaks of a pension fund. So as public employee pension funds skyrocket on the top end, the city had to make a special “Excess Benefit Plan” fund that has paid off $14.6 million to 110 employees over the past eight years.

The IRS limit for pension fund payments is $220,000 a year. Mind you, California has more than 60,000 retired public workers who earn six-figure annual pensions. There are retirees who are already hitting that ceiling. But in Los Angeles, thanks to a particularly corrupt special retirement program, the problem has escalated dramatically.

Los Angeles has a Deferred Retirement Option Plan (DROP), a special program that allows public safety employees to earn what they’d get paid as pensions for the last five years on the job while still earning their salary. Those pension payments are set aside in a fund and the employees get it all as a massive lump sum when they retire.

….
As Jack Dolan notes at the Times, these lump sum payments from the DROP program are pushing additional employees past the IRS limits for pension payments, and that’s also prompting the need for this new fund. That money comes out of the city’s pool of revenue, yanking away funding from infrastructure.

One beneficiary of this program is the Los Angeles Police Department’s new chief, Michael Moore, who “retired” briefly while a participant in DROP before being offered the top job. He got a $1.27 million payout from DROP and is now also making $350,000 a year on top of his pension. They’re now discussing how to reform the system to make it less prone to abuse, but Dolan notes that there’s little “appetite among city leaders” to eliminate the program because of the power public safety unions hold in Los Angeles.

More: You’re Paying Extra For LA’s Millionaire Retiree Pensions

LOS ANGELES, CA — LA’S Millionaire police and fire retirees have pensions so high, they exceed limits set by the Internal Revenue Service, which means Los Angeles taxpayers take a hit.

The city’s generous retirement plans for dozens of ranking officers forced the city to create an “Excess Benefit Plan” to pay the additional costs, an investigation by the Los Angeles Times found. The fund has paid more than $14.6 million to 110 retired employees since 2010, The Times’ analysis showed. That’s money that would otherwise go to fix sidewalks, fight homelessness or hire more officers.

The list of retirees consists of former cops and firefighters who got million-dollar payouts from a separate retirement program that drove their incomes well over the $220,000 annual limit the IRS allows pension funds to pay. The biggest retiree earner from last year was former LAPD Assistant Chief Earl Paysinger, whose $251,000 pension alone would have put him over the limit. But that $251,000 pension was hardly the bulk of his retirement income. He received an additional $1.3 million lump sum payment through the Deferred Retirement Option Plan. That 2016 payment catapulted him way over the top, requiring the city to pay more than half of his pension from the Excess Benefit Plan.
….
The Times’ investigation prompted Mayor Eric Garcetti and leaders of the police and fire unions to call for reform, requiring that people in DROP show up for about half of their scheduled hours in any given month in order to get the extra pension check. The proposal passed its first reading in the city council 12 to 0; a second vote is expected in January. A city report showed DROP has never been “cost-neutral” as was promised to voters in 2001.

Lovely.

FWIW, I searched in the 2009 presentation for reference to the tax limits… I did not find it. Mind you, limits existed even then.

So I will leave you with a final slide (it’s from the middle of the deck.)

Pity the poor actuaries! (who get paid, whether or not the pension fund does well)