The Impact of a DROP Program

on the Age of Retirement and Employer Pension

CostsSamson Alva, Norma B. Coe, and Anthony WebbCenter for Retirement Research at Boston College

Sixth International Longevity Risk and Capital Markets and Solutions ConferenceSydney, Australia

September 7-8, 2010

Defined Benefit Pension Plans

2

• Previous research shows that defined benefit (DB) pension plans incorporate age-related incentives that affect the age of retirement.

• For example – Friedberg and Webb (2005) estimate employees in DB plans retire two years earlier, on average, than those in DC plans.

• May disadvantage employees who would prefer to delay retirement

• May impose costs on employers if they result in premature loss of valued employees

Deferred Retirement Option Program (DROP)

3

• Some employers have responded by introducing a DROP.

• In the typical program we study:

• Eligible employees (those who have 10 years’ service and who have attained their Normal Retirement Age) can elect to enter the DROP and remain in it for a maximum of four years.

Deferred Retirement Option Program (DROP) (cont’d)

4

• On entry, employees cease to accrue additional pension benefits or pay pension contributions.

• During DROP participation, pension benefits are credited to a notional interest-bearing account in the employee’s name.

• Balance on the account is paid to the employee in a lump sum on eventual retirement.

Possible Effects

5

• Employees might enter the program at the age they would otherwise have retired.

• In that case, the program will be cost neutral, provided the interest rate on the DROP account equals the interest rate the employer can earn on the deferred pension benefits.

• We might then want to know who delays – are these workers more or less valuable to the employer than their putative replacements?

Possible Effects (cont’d)

6

• Employees might retire at the same age as before, but spend the last few years of their career in the DROP.

• Will only do this if it is to their financial advantage (and to the financial disadvantage of their employer!)

Questions We Examine

7

Using individual level data provided by a large public sector employer, we estimate:

• Impact of the DROP on the age of retirement

• Cost of program to the employer

• Whether highly valued employees are particularly likely to be induced by the program to delay retirement

Overview of Pension Plan Rules

8

Benefit accrual rate First 10 years 11-20 years 21+ yearsNormal retirement ageEarly retirement ageMonthly early retirement reduction

2.52.52.545400.5

2.52.52.055500.5

2.22.22.050400.5

2.22.02.060520.5

Hire date Pre-1988 Post-1988

Employee type Municipal

Municipal

Source: Samson Alva, Norma B. Coe, and Anthony Webb. 2010 forthcoming. “The Impact of a DROP Program on the Age of Retirement and Employer Pension Costs.” Working Paper. Chestnut Hill, MA: Center for Retirement Research at Boston College.

Police and fire Police and fire

% %% %

How Does the DROP Affect Pension Wealth Accrual and the Incentive to Retire?

9

a) DROP is available

b) Employees makes optimal use of it

Assume 2.5% inflation, 1.1% real wage growth, 3.0% real interest rate, population average mortality for the relevant birth cohort

Calculate expected present value of pension wealth by age assuming DROP is unavailable. Then recalculate program assuming:

$0

$100

$200

$300

$400

30 40 50 60 70 80

AgeMunicipal - early Municipal - normal Municipal - DROPFire/police - early Fire/police - normal Fire/police - DROP

10

Pension Wealth AccrualMale Born in 1970 Commencing Employment in 2000 at $40,000 Starting Salary

Real Discount Rate: 3%, Inflation: 2.5%, Real Wage Growth: 1.1%W

ealt

h in y

ear

20

09

dolla

rs,

dis

counte

d t

o a

ge 5

0, in

th

ousa

nds

Source: Samson Alva, Norma B. Coe, and Anthony Webb. 2010 forthcoming. “The Impact of a DROP Program on the Age of Retirement and Employer Pension Costs.” Working Paper. Chestnut Hill, MA: Center for Retirement Research at Boston College.

Dataset

11

Large municipal employer

• 63,558 employees in pensionable occupations between 1990 and 2008

After sample attrition:

Occupation

No. of employees

No. of person-years

Police 9,179 84,559

Fire 2,986 26,325

Municipal 27,448 200,943

Source: Samson Alva, Norma B. Coe, and Anthony Webb. 2010 forthcoming. “The Impact of a DROP Program on the Age of Retirement and Employer Pension Costs.” Working Paper. Chestnut Hill, MA: Center for Retirement Research at Boston College.

• Relative to the population, City employees are older and more likely to work in a blue collar job, have less education and longer tenure, and be members of a minority group.

12

Characteristics of Workers in City Pension Plan

• Fire and police officers are predominately male.

13

Estimation Strategy

• Estimate probit model to calculate effect of DROP on retirement hazard

• Estimate counterfactual retirement age for DROP-eligible employees

• Compare pension wealth of DROP-eligible employees at actual vs. counterfactual retirement age

• Sum to arrive at overall cost

Estimation Strategy (cont’d)

14

• Probit model – pooled person-year observations

• LHS variable binary indicator for whether the individual left voluntarily at age t or continued to work for the employer

• Estimate on everyone, on fire, police, and municipal employees separately

• Control for education, occupation, ethnicity, salary, years of service

• Plus full set of age dummies

P(Rt 1 | Xt )( XtB)

Estimation Strategy – Pension-Related Variables

15

• Difference between current and peak wealth/earnings

• Difference between current and peak pension wealth/earnings

squared

• At peak pension wealth

• One, two, three, four, five, six, seven, or more years past peak

• At early retirement age

• At normal retirement age

• After normal retirement age

• Pension wealth/earnings

Estimation Strategy – DROP-Related Variables

16

• DROP eligibility interacted with:

• Not-yet-attained peak pension wealth

• At peak pension wealth

•One, two, three, four, five, six, seven, or more years past peak

•Hypothesis – DROP will discourage retirement before peak and less than four years past peak. People incented to continue working will retire four or more years after the peak.

Regression Results: Selected Pension-Related Variables

17

All Fire

Police

Municipal

Difference between current and peak wealth/earnings

-0.00534 (0.000880)

*** -0.00816(0.00490)

* -0.0108(0.00198)

*** -0.00643(0.00130)

***

Squared difference between current and peak wealth/earnings

0.0000894(0.0000271

)

***0.000858

(0.000466)

*0.000151

(0.0000298)

*** 0.000294 (0.000113)

***

At peak pension wealth0.0452

(0.00392) *** 0.0370

(0.0111) *** 0.0118

(0.00445) *** 0.0485

(0.00551)***

One year past peak0.0720

(0.00539)*** 0.0314

(0.00958) *** 0.0337

(0.00602) *** 0.103

(0.00960) ***

Two years past peak0.0462

(0.00500) *** 0.00733

(0.00581) 0.0247

(0.00560) *** 0.0944

(0.0117) ***

Three years past peak0.0424

(0.00544) *** 0.00814

(0.00643) 0.0237

(0.00602) *** 0.0642

(0.0118) ***

Four years past peak0.0572

(0.00695) *** 0.0159

(0.00837) * 0.0362

(0.00792) *** 0.0447

(0.0118) ***

Five years past peak0.0439

(0.00736) *** 0.0214

(0.0105) ** 0.0195

(0.00689) *** 0.0495

(0.0154) ***

* Statistically significant at the 10 percent level; ** Statistically significant at the 5 percent level; *** Statistically significant at the 1 percent level.Source: Alva, Samson, Norma B. Coe, and Anthony Webb. 2010 forthcoming. “The Impact of a DROP Program on the Age of Retirement and Employer Pension Costs.” Working Paper. Chestnut Hill, MA: Center for Retirement Research at Boston College.

18

Regression Results: DROP Eligibility Interacted with Pension-Related Variables All Fire Police Municipal

Not yet attained peak pension wealth

-0.000419(0.00161)

0.00558(0.00695)

0.000172(0.00221)

-0.0108(0.00188)

***

At peak pension wealth -0.0163(0.00110)

*** -0.0119(0.00154)

*** -0.00131(0.00306)

-0.0212 (0.00130)

***

One year past peak -0.0157(0.00125)

*** -0.0115(0.00181)

*** -0.00937(0.00164)

*** -0.0174 (0.00189)

***

Two years past peak -0.0110 (0.00192)

*** -0.00443(0.00454)

-0.00462(0.00293)

-0.0196(0.00215)

***

Three years past peak 0.000840(0.00333)

-0.00557(0.00399)

0.0144(0.00682)

** -0.00621(0.00466)

Four years past peak 0.00842(0.00448)

* 0.00634(0.00885)

-0.0115(0.00169)

*** 0.0267(0.0104)

**

Five years past peak 0.0334(0.00806)

*** 0.0175(0.0135)

0.00637(0.00680)

0.0215(0.0120)

*

*Statistically significant at the 10 percent level; ** Statistically significant at the 5 percent level; *** Statistically significant at the 1 percent level.Source: Alva, Samson, Norma B. Coe, and Anthony Webb. 2010 forthcoming. “The Impact of a DROP Program on the Age of Retirement and Employer Pension Costs.” Working Paper. Chestnut Hill, MA: Center for Retirement Research at Boston College.

19

Estimating Counterfactual Retirement Age• At 3% real interest rate and 1.1% real salary growth, program delays retirement by:

• But people stay in the program for a median of four years

• So people enter the program at substantially younger ages than those at which they would otherwise have retired

Police 0.952

years

Fire 0.183

Municipal 1.270

20

Calculate Mean Cost Per Participant

• At 3% real interest rate and 1.1% real salary growth, and STRIP interest rates

Fire $38,700

Police $24,300

Municipal $29,700

• Why?

• Program accelerates payment to pension benefits.

21

Costs are Actually HIGHER at Higher Assumed Interest Rates

STRIP interest rate

8.25% nominal

Fire $38,700 $60,100

Police $24,300 $54,700

Municipal $29,700 $35,900

• Performance assessments not available for most employees

•Infer performance from salary increase relative to average for age and year

•Interact eligibility with “high quality”

•Program disproportionately affects high quality fire officers, but high quality police officers are less affected.

•Why? Outside options?

22

Are High Quality Workers Disproportionately Likely to Delay as a Result of the Program?

• Defined benefit pension plans incorporate strong age-related variations in pension wealth accrual.

• These variations in pension wealth accrual influence retirement behavior.

• DROP changes both incentives and behavior, and can be very expensive for the employer.

23

Conclusion