Is Your Compensation Philosophy Fair and Defensible?

[Editor's Note: We're delighted to publish this preview excerpt from Compensation Plans for Law Firms, 4th ed., soon to be published by the ABA Law Practice Management Section. For an extended interview with the author, see "Building a Comp Plan that Works" in our February 2003 edition. ]

Readers may look to this monograph (“Compensation Plans for Law Firms”) for the magic answers to their compensation questions. Unfortunately, there are none. Effective decision-making involves more art than science. An organization can get the job done right with a proper set of compensation “tools”: a methodology for making compensation decisions, a framework of criteria to apply, rational information on which to act, institutional knowledge of individuals and events, respected decision-makers, and, finally, the skills to apply the tools, interpret the information against the criteria, and communicate the decisions. Doing the job right is no easy task.

Numbers are Only a Tool

A wise individual reminds us of the difficulty of achieving this goal. He says: “Most compensation schemes will result, at best, in an absence of perceived unfairness. It is like saying that the best society can do is avoid war. It is the lack of negative rather than the existence of positive that allows one to judge a compensation system as a success or failure. Toward this lack of negative, I believe numerical information must be used as a tool to support management compensation decisions made using an equal (or greater) amount of nonquantifiable factors. Numerical information should never determine or even drive those decisions: it should provide the empirical basis, which avoids potential mistakes and backs up the final decisions.” Conversation with Robert M. Schack.

Compensation methodologies can span a wide spectrum, from formulas to equal sharing to enlightened subjectivity. Any single, pure approach has weaknesses. With formulas, the great danger is in believing that they can substitute for management decision-making and can address all possible scenarios. Much time can be spent refining numbers to make a formula yield an acceptable result. The hidden obstacle in equal-sharing systems is in a means to change the percentages. People come and go, and relative internal allocations need to change over time. Generally, it is the difficulty in adopting those changes that causes problems with such systems. Enlightened subjectivity is often hampered by two events: lack of an accepted successor to an enlightened decision-maker (“benevolent dictator”) who steps down, and a perceived inconsistency between compensation decisions and generally circulated management data.

If there is a universal rule regarding compensation, it is this: Every compensation system works, and every compensation system fails. Systems can run the spectrum from objective to subjective, participative to dictatorial. What works in a particular law firm is a system that fits the culture and strategy of the organization. That means that a good compensation system should be flexible; it should be able to survive evolving needs of the firm and produce decisions respected by those affected. A successful compensation system must be embraced by the partners and be consistent with their collective philosophy, background, and perspective.

Maintaining Perceived Equity in Evolving Organizations

Despite their differences, all successful compensation systems feature two linked, common qualities. First and foremost, a successful system is fair and perceived as fair by the partners who are essential to the firm's economic success and reputation. The perception of fairness is critical. Even a system that is objectively fair cannot survive if a substantial number of key players perceive it as unfair. Fairness should not be confused with satisfaction with one's own compensation. Fairness is measured by a sense of equity in the treatment of, and by, others. To determine the fairness of a compensation system, partners may want to ask themselves these questions:

• Do I understand the system?
• Does the system recognize what individuals contribute to the organization?
• Are the rules clear?
• Are the rules followed and applied in a consistent manner from person to person and from year to year?
• Are the compensation decision- makers trusted and respected?

These questions define the perception of fairness. Partners observe the relative levels of compensation among them and determine the “fairness” of the system in the context of those questions.

A second quality of successful compensation systems is that of simplicity. Altman Weil's experience has shown that there is a direct correlation between the simplicity of a compensation system and the degree to which wage earners understand how their compensation is determined. That, in turn, goes a long way toward the perception of fairness. Simplicity is the foundation. For each additional consideration or step in a compensation system, one might ask: “Are we gaining sufficient additional information about an individual's contribution to make it worth the additional complexity?”

The difficulty in structuring a compensation system for a law firm is in selecting the best mix of compensable criteria and the right amount of participation, consistent with the firm's needs and its culture. A law firm evolves over time. Because of these changes, the compensation system must function like a good constitution ' rules grounded in sound, basic principles and subject to amendment only after careful and thoughtful deliberation. The experience and objectivity of an expert outsider and the candor of confidential input often work together to maintain a desirable compensation system.

Expectations and Resources in a Competitive Profession

An important event in any law firm is the exchange of individual expectations regarding compensation:

• What are our objectives? Formal or informal?
• How much money is enough?
• How much money is not enough?
• What does compensation mean, both personally and professionally, to each individual?
• What level of risk-sharing should take place?
• How much disparity should exist from top to bottom?

These questions define much about how economic rewards can be fashioned and how they are divided among lawyers. They may even lead to a conclusion that there are partners and associates who should no longer be part of the firm.

An additional factor significant to compensation is that the legal profession is maturing, and the balance is shifting from the suppliers (lawyers) to the consumers (clients). The profession experienced an explosion in the number of lawyers, paralegals, and support personnel during the 1970s, 1980s, and 1990s. Positions that did not even exist in 1960 now have sophisticated trade associations ' for example, legal administrators have the Association of Legal Administrators (ALA), legal assistants have the National Association of Legal Assistants (NALA), and marketing directors have the Legal Marketers Association (LMA). Information Systems (IS) or Information Technology (IT) directors now preside over the deployment of technology throughout law firms.

Concurrent with growth in the numbers of personnel has been an explosion in the starting salaries of new law school graduates. Nationally, new lawyers' starting salaries rose from a median of $14,000 in 1973 to a plateau of $50,000 in 1989. Altman Weil^' Surveys of Law Firm Economics, (Altman Weil^' Publications, Inc., Newtown Square, PA, various years). That represented an increase of 257%, compared with a 184% increase in the consumer price index for the same period. Law firms then held the line on offers to recent graduates to a national median of $50,000 until 1995. In 1996, a small spike ' to $52,000 ' occurred, and then the median returned to $50,000 in 1997. However, in 1998, law firms raised starting salaries 10%, to a national median of $55,000. Id. In 1999 and 2000, the increases continued. In December 1999, a Silicon Valley law firm raised its starting salary to $125,000, with a guaranteed $20,000 bonus, and this was matched by many large-city firms in 2000. The national median starting salary in 2003 was just over $70,000.

Technology is just beginning to reshape the landscape for the delivery of legal services. The inroads to date, though impressive, have only touched the surface of what promises to be a fundamental shift. The implications of this shift are disruption, disequilibrium, and costly reorganization and investment. Couple this with aggressive pressure by clients to drive nonproductive costs out of their organizations, and the result is a legal market where vast changes are ' and will be ' taking place.

Illustration I.1 shows the change in relationships of compensation for four groups of lawyers, as compared with an index of compensation for recent law school graduates.

[IMGCAP(4)]

This illustration sets median starting salaries of recent graduates at a constant value of 100 and relates the median earnings of other groups to that value. Comparisons are made for fifth-year associates, partners with nine years of experience, partners with between 25 and 29 years of experience, and all partners as a group. In 1978, an experienced partner earned 4.7 times more than a new associate. The ratio generally declined until 1990, when it hit 3.6 (as the legal profession struggled with income compression and was on the verge of its own recession). By 1998 the ratio had improved to 4.3, only to fall back to 3.7 two years later. As of 2002, experienced partners earned 4.0 times more than a new associate.

Law is a very competitive profession. Even with the prosperous economic times, keeping good people is a challenge, as there always seems to be someone who is willing to pay more for the best people. Firms with less than stellar economics are hugely at risk for defections. This is because many of the problems in compensation systems, particularly owner compensation systems, relate not to the matter of income allocation, but to the overall economics of the practice. Often the compensation system is blamed when individual compensation is perceived as inadequate. But, with labor costs being such a significant component of law firm overhead, firm profitability is directly affected by each worker's compensation. In effectively dealing with problems in compensation systems, attention must be directed to the overall economics of a law firm's performance, as well as to the manner of income allocation.

Law firm owners must allocate limited economic resources among all the wage earners. As a consequence, there are no easy answers for compensation issues, and complete satisfaction is rarely possible. Firms must manage compensation risk, strive to attract and retain talented people, and stimulate them to pursue activities that contribute to the organization.

Concluding Observations: Firm Size, Revenue and Profitability

It is generally accepted that firm size is important to potential-partner income. There is some truth in this statement. According to Altman Weil's annual survey, the 2002 median compensation for equity partners was just under $163,000 in small firms, and just under $327,000 in large firms. See Illustration I.2.

[IMGCAP(1)]

However, if one looks at the AmLaw 200 and compares firm size with compensation, a different picture emerges. These law firms (excluding one firm with over 1800 lawyers and one firm with more than $2,000,000 profits per equity partner) range in size from approximately 140 lawyers to 1700 lawyers. Average equity partner profits range from approximately $280,000 to $2,000,000.

The highest per-equity partner profits were in a firm 5% the size of the largest firm. These were the two outliers excluded from the chart. Even when adjusted for outliers in firm size and profit per equity partner, there is little correlation in this group between size and per-partner profits. Size of firm had even less effect on a firm's ability to generate revenues per lawyer. However, revenues per lawyer did correlate strongly with profits per equity partner.

Let's extend that thinking and examine law firm profitability. See Illustration I.4.

[IMGCAP(2)]

The average 2002 firm income per lawyer (SLFE – Survey of Law Firm Economics) was $154,000 in small firms, and $275,000 in large firms. The chart resembles the partner compensation chart in Illustration I.2. If the most profitable 25% of firms in each size category are examined, the per-lawyer income ranges from $244,000 to $365,000 (see Illustration I.5), but it is not so nicely aligned with firm size. One should be careful not to assume that size is the only ' or even inescapable ' path to enhanced income.

[IMGCAP(3)]

[Editor's Note: We're delighted to publish this preview excerpt from Compensation Plans for Law Firms, 4th ed., soon to be published by the ABA Law Practice Management Section. For an extended interview with the author, see "Building a Comp Plan that Works" in our February 2003 edition. ]

Readers may look to this monograph (“Compensation Plans for Law Firms”) for the magic answers to their compensation questions. Unfortunately, there are none. Effective decision-making involves more art than science. An organization can get the job done right with a proper set of compensation “tools”: a methodology for making compensation decisions, a framework of criteria to apply, rational information on which to act, institutional knowledge of individuals and events, respected decision-makers, and, finally, the skills to apply the tools, interpret the information against the criteria, and communicate the decisions. Doing the job right is no easy task.

Numbers are Only a Tool

A wise individual reminds us of the difficulty of achieving this goal. He says: “Most compensation schemes will result, at best, in an absence of perceived unfairness. It is like saying that the best society can do is avoid war. It is the lack of negative rather than the existence of positive that allows one to judge a compensation system as a success or failure. Toward this lack of negative, I believe numerical information must be used as a tool to support management compensation decisions made using an equal (or greater) amount of nonquantifiable factors. Numerical information should never determine or even drive those decisions: it should provide the empirical basis, which avoids potential mistakes and backs up the final decisions.” Conversation with Robert M. Schack.

Compensation methodologies can span a wide spectrum, from formulas to equal sharing to enlightened subjectivity. Any single, pure approach has weaknesses. With formulas, the great danger is in believing that they can substitute for management decision-making and can address all possible scenarios. Much time can be spent refining numbers to make a formula yield an acceptable result. The hidden obstacle in equal-sharing systems is in a means to change the percentages. People come and go, and relative internal allocations need to change over time. Generally, it is the difficulty in adopting those changes that causes problems with such systems. Enlightened subjectivity is often hampered by two events: lack of an accepted successor to an enlightened decision-maker (“benevolent dictator”) who steps down, and a perceived inconsistency between compensation decisions and generally circulated management data.

If there is a universal rule regarding compensation, it is this: Every compensation system works, and every compensation system fails. Systems can run the spectrum from objective to subjective, participative to dictatorial. What works in a particular law firm is a system that fits the culture and strategy of the organization. That means that a good compensation system should be flexible; it should be able to survive evolving needs of the firm and produce decisions respected by those affected. A successful compensation system must be embraced by the partners and be consistent with their collective philosophy, background, and perspective.

Maintaining Perceived Equity in Evolving Organizations

Despite their differences, all successful compensation systems feature two linked, common qualities. First and foremost, a successful system is fair and perceived as fair by the partners who are essential to the firm's economic success and reputation. The perception of fairness is critical. Even a system that is objectively fair cannot survive if a substantial number of key players perceive it as unfair. Fairness should not be confused with satisfaction with one's own compensation. Fairness is measured by a sense of equity in the treatment of, and by, others. To determine the fairness of a compensation system, partners may want to ask themselves these questions:

• Do I understand the system?
• Does the system recognize what individuals contribute to the organization?
• Are the rules clear?
• Are the rules followed and applied in a consistent manner from person to person and from year to year?
• Are the compensation decision- makers trusted and respected?

These questions define the perception of fairness. Partners observe the relative levels of compensation among them and determine the “fairness” of the system in the context of those questions.

A second quality of successful compensation systems is that of simplicity. Altman Weil's experience has shown that there is a direct correlation between the simplicity of a compensation system and the degree to which wage earners understand how their compensation is determined. That, in turn, goes a long way toward the perception of fairness. Simplicity is the foundation. For each additional consideration or step in a compensation system, one might ask: “Are we gaining sufficient additional information about an individual's contribution to make it worth the additional complexity?”

The difficulty in structuring a compensation system for a law firm is in selecting the best mix of compensable criteria and the right amount of participation, consistent with the firm's needs and its culture. A law firm evolves over time. Because of these changes, the compensation system must function like a good constitution ' rules grounded in sound, basic principles and subject to amendment only after careful and thoughtful deliberation. The experience and objectivity of an expert outsider and the candor of confidential input often work together to maintain a desirable compensation system.

Expectations and Resources in a Competitive Profession

An important event in any law firm is the exchange of individual expectations regarding compensation:

• What are our objectives? Formal or informal?
• How much money is enough?
• How much money is not enough?
• What does compensation mean, both personally and professionally, to each individual?
• What level of risk-sharing should take place?
• How much disparity should exist from top to bottom?

These questions define much about how economic rewards can be fashioned and how they are divided among lawyers. They may even lead to a conclusion that there are partners and associates who should no longer be part of the firm.

An additional factor significant to compensation is that the legal profession is maturing, and the balance is shifting from the suppliers (lawyers) to the consumers (clients). The profession experienced an explosion in the number of lawyers, paralegals, and support personnel during the 1970s, 1980s, and 1990s. Positions that did not even exist in 1960 now have sophisticated trade associations ' for example, legal administrators have the Association of Legal Administrators (ALA), legal assistants have the National Association of Legal Assistants (NALA), and marketing directors have the Legal Marketers Association (LMA). Information Systems (IS) or Information Technology (IT) directors now preside over the deployment of technology throughout law firms.

Concurrent with growth in the numbers of personnel has been an explosion in the starting salaries of new law school graduates. Nationally, new lawyers' starting salaries rose from a median of $14,000 in 1973 to a plateau of $50,000 in 1989. Altman Weil^' Surveys of Law Firm Economics, (Altman Weil^' Publications, Inc., Newtown Square, PA, various years). That represented an increase of 257%, compared with a 184% increase in the consumer price index for the same period. Law firms then held the line on offers to recent graduates to a national median of $50,000 until 1995. In 1996, a small spike ' to $52,000 ' occurred, and then the median returned to $50,000 in 1997. However, in 1998, law firms raised starting salaries 10%, to a national median of $55,000. Id. In 1999 and 2000, the increases continued. In December 1999, a Silicon Valley law firm raised its starting salary to $125,000, with a guaranteed $20,000 bonus, and this was matched by many large-city firms in 2000. The national median starting salary in 2003 was just over $70,000.

Technology is just beginning to reshape the landscape for the delivery of legal services. The inroads to date, though impressive, have only touched the surface of what promises to be a fundamental shift. The implications of this shift are disruption, disequilibrium, and costly reorganization and investment. Couple this with aggressive pressure by clients to drive nonproductive costs out of their organizations, and the result is a legal market where vast changes are ' and will be ' taking place.

Illustration I.1 shows the change in relationships of compensation for four groups of lawyers, as compared with an index of compensation for recent law school graduates.

[IMGCAP(4)]

This illustration sets median starting salaries of recent graduates at a constant value of 100 and relates the median earnings of other groups to that value. Comparisons are made for fifth-year associates, partners with nine years of experience, partners with between 25 and 29 years of experience, and all partners as a group. In 1978, an experienced partner earned 4.7 times more than a new associate. The ratio generally declined until 1990, when it hit 3.6 (as the legal profession struggled with income compression and was on the verge of its own recession). By 1998 the ratio had improved to 4.3, only to fall back to 3.7 two years later. As of 2002, experienced partners earned 4.0 times more than a new associate.

Law is a very competitive profession. Even with the prosperous economic times, keeping good people is a challenge, as there always seems to be someone who is willing to pay more for the best people. Firms with less than stellar economics are hugely at risk for defections. This is because many of the problems in compensation systems, particularly owner compensation systems, relate not to the matter of income allocation, but to the overall economics of the practice. Often the compensation system is blamed when individual compensation is perceived as inadequate. But, with labor costs being such a significant component of law firm overhead, firm profitability is directly affected by each worker's compensation. In effectively dealing with problems in compensation systems, attention must be directed to the overall economics of a law firm's performance, as well as to the manner of income allocation.

Law firm owners must allocate limited economic resources among all the wage earners. As a consequence, there are no easy answers for compensation issues, and complete satisfaction is rarely possible. Firms must manage compensation risk, strive to attract and retain talented people, and stimulate them to pursue activities that contribute to the organization.

Concluding Observations: Firm Size, Revenue and Profitability

It is generally accepted that firm size is important to potential-partner income. There is some truth in this statement. According to Altman Weil's annual survey, the 2002 median compensation for equity partners was just under $163,000 in small firms, and just under $327,000 in large firms. See Illustration I.2.

[IMGCAP(1)]

However, if one looks at the AmLaw 200 and compares firm size with compensation, a different picture emerges. These law firms (excluding one firm with over 1800 lawyers and one firm with more than $2,000,000 profits per equity partner) range in size from approximately 140 lawyers to 1700 lawyers. Average equity partner profits range from approximately $280,000 to $2,000,000.

The highest per-equity partner profits were in a firm 5% the size of the largest firm. These were the two outliers excluded from the chart. Even when adjusted for outliers in firm size and profit per equity partner, there is little correlation in this group between size and per-partner profits. Size of firm had even less effect on a firm's ability to generate revenues per lawyer. However, revenues per lawyer did correlate strongly with profits per equity partner.

Let's extend that thinking and examine law firm profitability. See Illustration I.4.

[IMGCAP(2)]

The average 2002 firm income per lawyer (SLFE – Survey of Law Firm Economics) was $154,000 in small firms, and $275,000 in large firms. The chart resembles the partner compensation chart in Illustration I.2. If the most profitable 25% of firms in each size category are examined, the per-lawyer income ranges from $244,000 to $365,000 (see Illustration I.5), but it is not so nicely aligned with firm size. One should be careful not to assume that size is the only ' or even inescapable ' path to enhanced income.

[IMGCAP(3)]