Classification of Drop Benefits in Divorce
© 2004 National Legal Research Group, Inc.
Most employees who own defined benefit retirement plans elect to have the benefits paid directly to themselves, beginning on their chosen date of retirement. A number of plans, however, give the employee the option to defer the receipt of benefits for a period of time after benefits are first elected. These "deferred retirement option plans" or DROP programs are particularly common in plans established for state and local employees.
Only a few cases in recent years have considered the proper classification of DROP benefits. Three of these decisions, however, were released in the first four months of 2004 alone. If these cases are any guide, issues involving DROP plans are likely to arise in the future with increasing frequency.
How DROP Programs Operate
An employee elects to participate in a DROP program when his or her retirement benefits become payable. Under the program, the employee is treated as if he had retired for purposes of the plan. Creditable service stops accruing, the final monthly benefit amount is computed, and the plan begins paying benefits. Instead of paying the benefits to the employee, however, the plan pays the benefits into an account in the employee's name. Payments into the account share in any cost of living adjustments (COLAs) paid to plan members generally, just as they would if the employee had retired normally. In addition, like a defined contribution account, a DROP account earns interest.
The most important feature of a DROP program is the manner in which creditable service is determined. Defined benefit plans always compute the monthly amount payable to the employee at some function of years of service and/or salary. As the name implies, a DROP program is intended only to defer receipt of retirement benefits. It cannot give the employee new retirement benefits as a result of additional service, for the entire foundation of a DROP program is the assumption that the employees has elected to retire. The employee's base retirement benefit is therefore computed just as if he or she had actually retired on the date of entry into the DROP program, using years of service and salary figures computed as of that date. The base retirement benefit can increase because of COLAs, and the benefits accumulated in the DROP account can increase in value because of interest, but the employee does not acquire any new retirement benefits as a result of participation in the DROP program. Rather, the DROP account receives only those benefits which the employee would have received if he or she had retired normally on the date of entry into the program.
Many participants in DROP programs continue to work for the employer after entering into the program. The programs therefore function in some ways as the opposite of early retirement, allowing the employee to retire for purposes of the plan while still working for the employer. To repeat, however, the employee acquires no additional retirement benefits as a result of service provided during the deferral period. If two employees enter the DROP program on the same date, with equal base retirement benefits and equal rights to future COLAs, they will accumulate benefits at exactly the same rate, regardless of the quality of their work after entry into the program. Indeed, at least some DROP programs do not require the employee to keep working for the employer at all. In this sort of program, if one employee in the above example elects to continue working for the employer during the deferral period and the second employee elects not to work for the employer, both employees will still accrue retirement benefits at the same rate. Employees who choose to work after electing to join a DROP program are compensated with additional salary and other benefits, but the amount of their retirement benefits is still computed on the assumption that they retired normally on the date of entry into the program.
When the deferral period ends, the benefits accumulated in the DROP account are payable to the employee. They can always be taken in a lump-sum payment, and in some plans can be withdrawn gradually over time. If the employee dies before the DROP account is exhausted, any remaining balance is paid to the employee's estate. Thus, while the time of receipt may be uncertain, it is absolutely certain that the employee (or the employee's heirs) will eventually receive all of the benefits in the DROP account. The substance of the program is exactly what its name implies: a device by which retirement benefits earned before entry into the program can be held in an account, earning interest at a reasonable rate, and paid to the employee at a later time.
For purposes of division upon divorce, employees who participate in a DROP program have two independent types of retirement benefits. The first benefit is the lump sum payable when the period of benefit deferral ends. The second benefit is the normal right to receive a monthly retirement check, sent directly to the employee and not deposited into the DROP account, after the employee no longer participates in the DROP program.
The first benefit, the lump sum payable upon leaving the DROP program, can further be subdivided into the raw unappreciated amount of retirement benefits deposited into the DROP account (the base retirement benefit, multiplied by the total months of payment), benefits traceable to COLAs received during the period of deferral, and interest earned on the account balance during the period of deferral.
Because DROP programs fundamentally permit the employee to delay receipt of retirement benefits already earned, the strong general rule is that retirement benefits paid into a DROP account are given exactly the same classification that they would have received if the DROP program had not been elected.
For example, assume that an employee's retirement benefits mature after 25 years of creditable service under a defined benefit plan. Assume further that the employee had 10 years of creditable service before the marriage, and 15 years of creditable service during the marriage. If the employee did not choose to join a DROP program, each retirement benefit check would be 15/25 or 60% marital property. Since DROP programs change only the date on which benefits are received, and not the date on which benefits are earned, the benefit checks are also 60% marital property if deposited into a DROP account.
Cost of living adjustments during the period of deferral under a DROP plan are classified in the same manner as the base benefit checks. COLAs received after retirement are normally treated as passive appreciation in the value of the existing monthly benefit. Continuing the above example, if 60% of an employee's base retirement benefit is marital, then 60% of all future COLAs are likewise marital. This result makes sense, for the purpose of a COLA is to protect the entire benefit from inflation, not just the marital or nonmarital portion.
Interest earned on the DROP account likewise reflects passive appreciation on the existing plan balance. In most circumstances, there is no reason to assume that the marital and nonmarital portions of the account earned interest at different rates. Thus, in the above example, 60% of the interest earned on the account is marital. Because the 60% figure applies to all three components of the account base retirement benefits, COLAs, and interest it is generally accurate to say that DROP benefits are subject to the same percentage of marital interest as the base retirement amount.
Because the amount of the employee's base retirement benefit is computed as if the employee had taken normal retirement on the date of entry into the DROP program, time spent working for the employer during the deferral period is generally not included in computing the marital share of the benefits. In the above example, where the employee had 10 years of creditable premarital service and 15 years of creditable marital service, the marital interest is fixed at 60%, even if the employee chooses to work for an additional five years during the deferral period. This result is particularly required where the employee would have received the same benefits if he or she had elected to join the DROP program but had not elected to continue working for the employer. In that situation, none of the benefits can possibly be consideration for efforts during the deferral period, for the same amount would have been received if no such efforts had been put forth.
Classification: Reported Cases
The first equitable distribution decision to consider DROP benefits was Dial v. Dial, 74 Ark. App. 30, 44 S.W.3d 768 (2001). The husband in that case elected to join a DROP program during the marriage. He was divorced during the deferral period, and his retirement benefits were 45% marital property. The trial court nevertheless held that the entire balance in the DROP account was separate property, apparently because the balance was not payable until after the divorce. The Arkansas Court of Appeals reversed:
Mrs. Dial argues on appeal that she should have been awarded 50 percent of the funds held by Mr. Dial in his DROP account at the time of the divorce. We agree. Had the funds in the DROP account been paid directly to Mr. Dial during the marriage and placed by him into an ordinary savings account, they would unquestionably be considered marital property subject to division. The fact that Mr. Dial has chosen to postpone enjoyment of those funds does not destroy Mrs. Dial's interest in them. See Day v. Day, 281 Ark. 261, 663 S.W.2d 719 (1984). We therefore hold that any money accumulated in the DROP account during the marriage, that is, prior to entry of the April 5, 2000 divorce decree, constitutes marital property of which Mrs. Dial is entitled to a 50 percent interest.
74 Ark. App. at 35-36, 44 S.W.3d at 768.
The court properly rejected the trial court's holding that none of the funds in the DROP account were marital, but it is unclear why all of the funds in the DROP account should have been marital. The marital interest in the entire plan was only 45%. Logically, 45% of each payment into the DROP account should likewise have been marital, regardless of whether the payment was made before or after the divorce. The husband in Dial did work for his employer during the deferral period, but the 45% figure was clearly based upon time of service before the date on which the husband elected DROP benefits. Thus, the benefits were clearly not consideration for efforts during the deferral period. The issue is rendered somewhat more complex by the fact that the wife apparently requested only 50% of the balance on the date of divorce, so she received the only amount she requested. But the logically proper result was to give the wife 22.5% (50% of 45%) of all of the retirement benefits deposited into the account, either before or after divorce.
The most recent equitable distribution decision to consider DROP benefits analyzed the issue much more perceptively. In Swanson v. Swanson, 869 So. 2d 735, 2004 WL 736050 (Fla. 4th Dist. Ct. App. 2004), the marital interest in the husband's retirement benefits was 45%. The husband elected to participate in a DROP program, and divorce occurred during the deferral period. The trial court recognized that the 45% of base retirement benefits deposited into the DROP plan were marital property. It refused to award the wife any portion of postdivorce COLAs or interest; however, it reduced the husband's benefits by an entirely hypothetical early retirement discount, and it offset one party's monthly retirement benefits against the other's even though the wife was not yet receiving her benefits. On appeal, the trial court was reversed on each count. With regard to the COLAs and interest, the court stated:
[A]s is obvious, 45% of the value of the former Husband's pension benefits as of January 17, 1990 belongs to the former Wife. Therefore, the interest and cost of living adjustments which were applied to the former Wife's share, despite being in the former Husband's DROP account, should also belong to the former Wife. Moreover, the former Wife sufficiently established that the DROP account received a 3% cost-of-living adjustment on the first day of each July, and it accrued tax deferred interest "at an effective annual rate of 6.5 percent compounded monthly, on the prior month's accumulated ending balance, up to the month of termination or death." 121.091(13)(c), Fla. Stat. Therefore, we hold the trial court erred by not awarding the former Wife interest and cost of living adjustments which accrued in the former Husband's DROP account.
2004 WL 736050, at *3.
The actual holding of the Swanson court was that the wife was entitled to "45% of the value of the former Husband's pension benefits as of January 17, 1990," plus postdivorce COLAs and interest on her share of the account. In construing this phrase, it is important to understand that January 17, 1990 was the date of divorce and that the husband did not elect to join the DROP program until 1998. Thus, the above passage does not limit the wife to 45% of the DROP balance on the date of divorce. Rather, the marital estate is awarded from the DROP account a sum equal to 45% of the monthly amount the husband would have received had he retired on January 17, 1990, with no DROP election in place, multiplied by the 55-month deferral period, plus COLAs and interest on that amount. In other words, for each of the 55 monthly payments, the marital share is 45% of the accrued benefit on the date of divorce, plus COLAs and interest.
Note also that Florida follows the minority rule that postdivorce, merit-based increases in retirement benefits are separate property. Boyett v. Boyett, 703 So. 2d 451 (Fla. 1997). The wife's interest in each monthly payment into the DROP account had to be limited to 45% of the accrued benefit on the date of divorce because the husband's accrued benefit may have increased between the date of divorce and the date of entry into the DROP program. Those increases were separate property under Boyett. If Florida followed the majority rule that the percentage of marital share attaches to all postdivorce benefit increases, see generally Brett R. Turner, Equitable Distribution of Property 6.10 (2d ed. 1994 & Supp. 2003), the court could simply have awarded the wife 45% of any future distributions from the DROP account.
Swanson's holding also shows why Dial was wrong to limit the wife to 50% of the value of the DROP account on the date of divorce. Accrued retirement benefits are not a lump sum but, rather, an annuity the right to receive a stated sum per month for the remainder of the participant's lifetime. Under a DROP program, benefits payable during the deferral period are placed into the DROP account. But this placement does not change the time at which the benefits were earned. As Dial properly held, the situation is conceptually no different from what would result if the husband received the same payments and placed them into a savings or investment account. If the husband in Dial had done that, each benefit check due after the divorce would have been 45% marital property, and the account balance would have been 45% marital. For exactly the same reason, the wife in Dial should have received 22.5% of the entire account, and not 50% of the balance on the date of divorce. DROP benefits are not consideration for efforts put forth during the deferral period.
The highest court of Maryland recently dismissed an action seeking a declaratory judgment that DROP benefits were not marital property. The action was filed by a group of employees participating in the DROP program after the plan administrator determined that the employees' former spouses were entitled to their proper marital share of all benefits withdrawn from the DROP accounts at issue. The trial court expressly affirmed the administrator's decision. The decision was reversed on appeal, on the basis that the employees had not exhausted their administrative remedies. Brown v. Fire & Police Employees' Retirement System, 375 Md. 661, 826 A.2d 525 (2003). The appellate court did not reach the merits of the issue. In all of the other cases discussed in this article, the division of DROP benefits arose in the context of divorce or postdivorce proceedings.
The largest body of law on DROP benefits comes from the community property state of Louisiana. The leading case in that state is Bailey v. Bailey, 708 So. 2d 354 (La. 1998). The husband in Bailey began working for his employer in 1963, and he was married to the wife in 1977. The husband elected to participate in a DROP program in 1993, with a three-year deferral period. He was divorced a year later, before the deferral period ended. The trial court awarded the wife her marital share of deposits into the DROP account before the effective date on which the marital community ended but held that all deposits into the DROP account after that date were separate property. The Louisiana Supreme Court reversed:
The employment and retirement contributions that gave rise to Mr. Bailey's right to have funds credited to the DROP account occurred prior to and during the existence of the community, and not after the termination. It follows then that the right to receive the funds in the DROP account, at least the portion attributable to Mr. Bailey's labor and efforts and retirement contributions during the existence of the community prior to entering the DROP program, constitutes a community asset.
Id. at 357 (footnotes omitted).
In the case of ordinary retirement benefits, the non-employee spouse's right to share is calculated under the Sims formula as of the date the community terminates, but the exact percentage cannot be fixed until the employee spouse actually retires. In the DROP context, however, the Sims formula must be applied as of the date of the employee spouses's entry into the DROP program, because that is the date the base amount of the eventual monthly retirement benefits is fixed, and the employee spouse earns no further credit toward these retirement benefits while in the DROP program. Significantly, the trial court applied the Sims formula as of the date Mr. Bailey entered DROP, albeit without discussion. Thus the trial court implicitly recognized that Mrs. Bailey's right to share in Mr. Bailey's eventual monthly retirement benefits was fixed as of that date, but then proceeded to treat Mrs. Bailey's right to share in the DROP account as if the funds in that account were attributable to Mr. Bailey's employment after he entered the DROP program. This is where the trial court erred.
If Mr. Bailey had actually retired on the date he entered the DROP program, Mrs. Bailey clearly would have had the right to share, in the stipulated percentage, in the retirement benefits he would have received. The fact that the same amount of monthly retirement benefits was credited to a deferred-receipt account under a fictitious retirement for a specific temporary period should not change that result.
Id. at 358.
Shortly after Bailey, an intermediate appellate decision refused to reach the same result in a case where the employee elected DROP benefits 17 years after the divorce. Schlosser v. Behan, 722 So. 2d 1129 (La. Ct. App. 5th Cir. 1998), writ denied, 739 So. 2d 791 (La. 1999). It distinguished Bailey on the basis that the marriage in that case existed for part of the deferral period. There is no logical reason why the passage of time between divorce and the election of DROP benefits should matter. No matter how much time passes between divorce and retirement, retirement benefits are still marital or community property to the extent acquired during the marriage. The marital or community interest cannot be reduced simply because the employee spouse voluntarily chose to defer receipt of the benefits. An entire host of later Louisiana cases criticize Schlosser on this basis and refuse to follow it. The leading Louisiana Fourth Circuit decision is typical:
We do not agree with the conclusions reached by our colleagues on the Fifth Circuit in the Schlosser v. Behan case, and therefore, we decline to follow that decision. Specifically, we do not agree with the Schlosser court's holding that the Bailey case is distinguishable and not controlling in a situation where a former spouse's entry into the DROP program occurred after the termination of the community. Even though the Bailey case involved funds deposited into the DROP program both during the community and after the termination of the community, the fact remains that the Supreme Court determined that funds deposited to DROP after the termination of the community were community property subject to partitioning in accordance with the Sims formula.
Zalfen v. Albright, 791 So. 2d 800, 802 (La. Ct. App. 4th Cir. 2001), writ denied, 803 So. 2d 31 (La. 2001); see also McKinstry v. McKinstry, 824 So. 2d 1260 (La. Ct. App. 2d Cir. 2002), writ denied, 834 So. 2d 438 (La. 2003); Lodrigue v. Lodrigue, 817 So. 2d 466 (La. Ct. App. 3d Cir.), writ denied, 826 So. 2d 1124 (La. 2002); Sullivan v. Sullivan, 801 So. 2d 1093 (La. Ct. App. 3d Cir.), writ denied, 800 So. 2d 876 (La. 2001); Bullock v. Owens, 796 So. 2d 170 (La. Ct. App. 2d Cir. 2001); Zalfen v. Albright, 791 So. 2d 800 (La. Ct. App. 4th Cir. 2001); see also Kenneth Rigby, Matrimonial Regimes: Recent Developments, 60 La. L. Rev. 405 (2000) (criticizing Schlosser). It is mildly surprising that the Louisiana Supreme Court has denied review over both Schlosser and most of the cases criticizing it. Nevertheless, outside of the Fifth Circuit of the Louisiana Court of Appeal, the persuasive value of Schlosser is probably minimal.
The division of DROP benefits also recently arose in the community property state of Texas. In Stavinoha v. Stavinoha, 126 S.W.3d 604 (Tex. App. 2004), the husband joined the Houston Police Department four years before the marriage. Many years later, he became eligible to retire and elected DROP benefits, continuing to work during the deferral period. Five years later, before the end of the deferral period, the parties were divorced. The trial court held that the deposits into the DROP account before the divorce were part community and part separate property, but it held that deposits into the DROP account and COLAs received after the divorce were both separate property.
In perhaps the best-written of all decisions on the subject, the Texas Court of Appeals reversed. The court stressed that DROP benefits are not consideration for services rendered to the employer during the deferral period:
The statutory scheme expressly provides that, when a member of the HPOPS chooses to enter the DROP, all retirement benefits are set as if the member had actually retired and begun receiving his pension on the date the member elected to enter the DROP. A member who participates in the DROP cannot accrue additional service credit even though he continues to work and any increases in pay that occur after entry into the DROP cannot be used in computing the monthly pension benefit.
Id. at 611.
In short, since his election to participate in the DROP, nothing that Paul has done or has failed to do either pre-divorce or post-divorce can affect the basic retirement benefits which were vested on May 10, 1995, and frozen on November 18, 1995. While Paul continues to work for the police department, the DROP election only means that Paul has deferred receipt of retirement benefits which he earned by virtue of his work from May 10, 1975 through November 18, 1995. The fact that Paul is currently deferring receipt of retirement benefits while they are credited into his DROP account does not alter the community property character of the retirement benefits, most of which were earned by virtue of work during the existence of the community, vested during the existence of the community, and were frozen in value when Paul "retired" in November 1995, prior to the divorce.
Id. at 612. Because postdivorce deposits into the DROP account came from benefits earned both before the date of election of DROP benefits and before the divorce, the court held that those benefits were not entirely separate property:
[T]he mere fact that the DROP credits are made post-divorce does not mean they are benefits that are earned post-divorce. Paul points to no evidence that the DROP credits and the other benefits at issue were earned by him as a result of his continued employment, such as by raises, promotions, services rendered, or contributions. The assertion that Paul "must" work to participate in DROP is unpersuasive and unsupported by the evidence. As we noted above, Paul chose to enter the DROP and continue working instead of retiring and receiving retirement benefits immediately, and by participating in the DROP, he receives the benefits of that participation. Even Paul's witness, Patrick Franey, who administers the DROP, testified that there is no statutory provision that requires the member who has made a DROP election to continue working after the election, and it is simply a matter of choice on the part of the member.
Id. at 614. The husband's expert's admission that members who had elected DROP benefits were not required to continue working was particularly fatal to the husband's position. But even if work had been required, the clear fact was that the husband did not acquire any additional retirement benefits as a result of his DROP election. As Dial noted, if the husband had refused to make that election, and had instead placed his retirement benefits into a private investment account earning the same rate of return, the community would have received the total community deposits, plus a proportional share of the return. The truly crucial fact was that the husband did not acquire any additional retirement benefits by joining the DROP program.
The Stavinoha court also considered whether the period of deferral counted as creditable service for purposes of measuring the marital share of the plan. If the deferral period was creditable service, the community interest had to be measured using the formula set forth in Berry v. Berry, 647 S.W.2d 945 (Tex. 1983). If no creditable service occurred after the divorce, the community interest had to be measured using a different formula set forth in Taggart v. Taggart, 552 S.W.2d 422 (Tex. 1977). The court held that the deferred period was not creditable service under the plan, so that the Taggart formula was applicable:
Here, Paul and Maureen were still married when Paul elected to participate in the DROP. If Paul had instead chosen to retire at that time, there would be no question that the Taggart formula would be applicable, because there could be no post-divorce labors that could increase the value of the retirement benefits. Because all of the benefits were vested at the time Paul entered the DROP, and because he is considered "retired" for purposes of determining his benefits under the DROP, Paul is likewise effectively retired for purposes of characterizing the retirement benefits. There is no danger that any post- divorce labors will increase the retirement benefits to implicate the application of the Berry valuation formula. We therefore hold that this situation is more analogous to Taggart than Berry, and thus the Taggart apportionment formula is applicable.
126 S.W.3d at 616. Bailey likewise held that the deferral period was not creditable service, although a dissenting opinion argued otherwise. 708 So. 2d at 360 (Traylor, J., concurring and dissenting). The dissent was limited to the creditable service issue; it agreed that postdivorce deposits into the DROP account were community property to the extent that the benefits depositing were earned during the marriage.
The plan in Stavinoha did give the husband a lump-sum bonus of $5,000 simply for joining the plan. Like a professional athlete's signing bonus, this amount was treated as community property because the husband joined the DROP plan during the marriage.
Under all of the DROP plans involved in the reported cases to date, no new retirement benefits were acquired as a result of service during the deferral period. It is conceptually possible, however, that a DROP program might exist in which at least some deposits into the DROP account are compensation for efforts during the deferral period. At a minimum, those deposits would have to be something more than the retirement benefits which the employee would have received if he or she had not joined the DROP program. Retirement payments which were payable before the DROP program was elected cannot be compensation for efforts made during the deferral period. But there is no reason why an employer could not agree, for example, to make additional contributions to the DROP account in stated amounts only for employees who worked for the employer during the deferral period. If those amounts were not payable to employees who did not join the DROP program, then the amounts would be earned during the deferral period. Cf. Bailey (noting that husband had accumulated supplemental retirement benefits by continuing to work for the employer after the deferred period ended and holding that those benefits were separate property). But no DROP plan involved in the reported cases to date has awarded supplemental retirement benefits as consideration for service rendered during participation in the DROP program.
Where no additional retirement benefits are awarded to those who participate in a DROP program, deposits into the DROP account are nothing more than retirement benefits earned before entry into the program. To the extent that creditable service before entry into the program occurred during the marriage, the benefits deposited into the account are marital or community property. The marital or community estate should receive the marital funds deposited, plus a proportional share of future COLAs and interest.