DROP – The Holding Bin for Your Pension Check

DROP is a program that allows you to retire without terminating your employment while your retirement benefits accumulate in a separate account earning 1.3% as of July 1, 2011. Previously, the earnings rate was 6.5%. In essence, you retire under the FRS Pension Plan and then have the ability to aggregate a lump sum cash benefit. At the end of your DROP period of 5 years, you must terminate employment. For a more complete description of DROP, please refer to the Frequently Asked Questions about DROP prepared by the State of Florida Division of Retirement available within www.myfrs.com.

DROP is not extra money or some kind of bonus. It is simply holding your pension check while you are continuing to work for the State. DROP participation means you retired under the FRS Pension Plan based upon your years of service at the time you elected DROP participation. By retiring at that time, your subsequent retirement benefit that would accrue over the next five years is set aside in a lump sum payment. However, your monthly check that you receive from the FRS Pension is less than it would be since the five years you spend in DROP do not count for the FRS Pension Plan calculation. In addition, the earnings rate on these DROP monies has been reduced from 6.5% to 1.3%. This drop in interest rate really undermines the value of DROP particularly considering that your years in DROP don’t increase your benefits under the Pension Plan.

The DROP balance should be rolled over to either the FRS Investment Plan or an Individual Retirement Account (IRA) upon leaving the state’s employment in order to properly manage taxes and retirement income. This rollover should be done properly in order to avoid full taxation of the lump sum amount. As you use this DROP amount to provide retirement income, regular income taxes will apply. By using an IRA you set the proper tax withholding rather than being subject to the 20% mandatory withholding that applies for direct DROP or FRS Investment Plan withdrawals.

However, if you are under the age of 59½ at retirement than you want to roll your DROP over to the FRS Investment Plan if you plan to use your DROP monies over time. Assuming you meet certain parameters (over age 50 and special risk or over age 55 and regular class), you are able to avoid the 10% penalty for early withdrawal by drawing directly from DROP. Alternatively, you could use the FRS Investment Plan (if over age 55) to provide penalty free access to these DROP monies over time. A major distinction between DROP and the FRS Investment Plan is that the DROP rules specifically recognize the age 50 public safety employee exemption as an exception to the normal 10% early distribution penalty. Meanwhile, the FRS Investment Plan does not specifically recognize this age 50 exception and only provides for the usual age 55 exemption. This is where your age, your job and where your money winds up starts to really matter if you want to reduce your taxes in retirement.

The FRS Pension Plan – The Guaranteed Check a Month Club

The oldest retirement option within the FRS is the Pension Plan. The Pension Plan is a defined benefit plan where your benefit of a monthly retirement check is defined by law. The amount of this check is determined by your years of service, your creditable service percentage and your average final compensation. In addition, you select from among four different options for your retirement income. The two most popular options are Options 1 and 3. Option 1 generates the most amount of income but ends when you die and Option 3 generates income for you and then your spouse when you die but with a reduction in income over Option 1 of typically 15-20% depending upon the age of your spouse.

This retirement income amount is annually supplemented in retirement by the application of a cost of living adjustment (COLA). However, the COLA has been suspended effective July 1, 2011 which results in a reduction of the prior COLA benefit of 3% per year. Despite better finances in Tallahassee, there has been no suggestion about reinstating this COLA in the future. Consequently, the COLA continues at 0% for all years of services after 2011. For retirees under the Pension Plan, your COLA in retirement is calculated by adding the number of years at 3% to the number of years at 0% and then dividing by your total number of years as a state employee. This average then becomes your COLA that will be permanently applied to your pension check in retirement.

Effective for new employees after July 1, 2011, retirement eligibility has increased to age 65 or 33 years for regular class and age 60 or 30 years for special risk class. Previously, normal retirement was age 62 or 30 years for regular class and age 55 or 25 years of service for special risk class. The vesting period for the Pension Plan has also increased from six to eight years for new employees hired after July 1, 2011. In addition, a 3% employee contribution is required that goes into the general Florida Retirement System. This effectively serves as a 3% reduction in employee compensation.

For a more complete description of the FRS Pension Plan, please refer to the Frequently Asked Questions about the Pension Plan and the Pension Plan Summary prepared by the State of Florida Division of Retirement. Both of these documents can be found within www.myfrs.com.

In summary, the FRS Pension Plan is a traditional check a month retirement plan. This check is guaranteed by the state to last for your lifetime or, with a reduction in income, for a set period of time or the life of another like your spouse. There is never any ability to utilize lump sum amounts from the Pension Plan nor leave a legacy to your beneficiaries. For some, this is the appeal of the Deferred Retirement Option Program (DROP).

A few years ago, we wrote a booklet describing the various retirement options to the state of Florida employees. We recently updated this booklet, The State of Your Retirement Third Edition by Joel J Garris. Over the next few weeks we will be posting individual chapters as a blog post. If at any time you would like a completed copy of the booklet, you can download it from our website at https://www.nelsonfinancialplanning.com or call the office at (407)629-6477 for a printed copy.

Introduction

The purpose of this booklet is to provide a single source resource to state employees who are nearing retirement. If you are a member of the Florida Retirement System (FRS), you have seen a lot of changes to your retirement options over the past few years. The state of your retirement has changed dramatically and what made sense in the past often does not make sense today.

We regularly meet with state employees to help them figure out these ever changing options. These meetings generally focus on reviewing the pros and cons of your retirement choices to help you make an informed decision and are done as a free service to you. To learn more about us, please review the section “What Makes Nelson Financial Planning Different?” on page 35 of this booklet.

While you are working, we keep you informed on a continuous basis by mailing FRS Update letters every few months or so. We do not charge for this ongoing service. Simply put, keeping you informed about the latest legislative changes and market performance while you are still working is somewhat straightforward. It also gives you an opportunity to try us out before you’ll really need us in retirement.

As a current employee, your options have changed a lot since 2008. These changes fundamentally shift your retirement options. Be sure to read the section on page 15 entitled “Shifting Sands for Current Employees – The Litany of Changes since 2008”.

Once you retire, things get a lot more complicated. Our focus shifts to providing personalized retirement income strategies to meet your unique retirement expenses and tax liabilities. These income needs are ever changing and the tax implications in retirement are very important. There are a variety of accounts available as a state employee and each has different tax implications depending on your age and job. Your investment focus also shifts to a more growth and income oriented mix which is very different from the approach used while working. Simply put things get a lot more complicated in retirement and that’s when our customized advice applies. Be sure to read the section on page 27 entitled “Retirement Income – Your Age and the Account Matters.”

This third edition of the booklet not only updates your retirement options within the Florida Retirement System but also adds a separate chapter on two important topics not previously discussed. First, there is a chapter now on deferred compensation or 457 plans. These accounts are funded solely from your pay check and provide flexible options for usage in retirement. Second, the chapter on the Health Insurance Subsidy details this often forgotten benefit of being a state retiree. This is a valuable benefit that helps to offset the growing cost of health insurance and is available to every retiree regardless of whether they retire under the Pension or the Investment Plan.