Drop dynamics plays a central role in defining the interfacial morphology in two-phase complex fluids such as emulsions and polymer blends. In such materials, the components are often microstructured complex fluids themselves. To model and simulate drop behavior in such systems, one has to deal with the dual complexity of non-Newtonian rheology and evolving interfaces. Recently, we developed a diffuse-interface formulation which incorporates complex rheology and interfacial dynamics in a unified framework. This paper uses a two dimensional implementation of the method to simulate drop coalescence after head-on collision and drop retraction from an elongated initial shape in a quiescent matrix. One of the two phases is a viscoelastic fluid modeled by an Oldroyd-B equation and the other is Newtonian. For the parameter values examined here, numerical results show that after drop collision, film drainage is enhanced when either phase is viscoelastic and drop coalescence happens more readily than in a comparable Newtonian system. The last stage of coalescence is dominated by a short-range molecular force in the model that is comparable to van der Waals force. The retraction of drops from an initial state of zero-velocity and zero-stress is hastened at first, but later resisted by viscoelasticity in either component. When retracting from an initial state with pre-existing stress, produced by cessation of steady shearing, viscoelasticity in the matrix hinders retraction from the beginning while that in the drop initially enhances retraction but later resists it. These results and the physical mechanisms that they reveal are consistent with prior experimental observations. (c) 2005 Elsevier B.V. All rights reserved.