Perils Of Unfunded Obligations: 4 Key Questions

Editor's Introduction

As summarized by A&FP Board member Bill Brennan of Altman Weil, Inc. an “unfunded retirement program” is essentially a promise to pay partners a retirement benefit in the future from the firm's future profits. About 24% of law firms have an unfunded retirement plan (down from 57% in 1990), according to the 2005 Retirement and Withdrawal Survey for Private Law Firms, prepared by Altman Weil, Inc. In about 15 years over 30,000 lawyers will be retiring each year. To the extent these partners must be paid retirement benefits from the then-current profits of their respective law firms, those firms unprepared for this potentially huge financial liability will be at risk, and some may not survive.

Former A&FP Board member Jim Cotterman, also of Altman Weil, has done some new writing about retirement plans recently [see "Related Resources"]. Jim also suggested the four questions around which this virtual-roundtable discussion was organized:

1. What are the challenges of traditional unfunded programs?
2. What remedies exist to mitigate the challenges?
3. Can a traditional unfunded program still work? If yes, what parameters create a “safe harbor”?
4. What effect will the approaching retirement of the baby boomer generation have on unfunded plans?

Problems with unfunded retirement plans are currently big news in the general business world, so law firms struggling with their plans are certainly not in totally unique straits. Law firms do have some distinctive concerns, however. For example, many firms are organized under difficult-to-change partnership agreements, many have experienced soaring growth in baseline compensation, and many are finding it hard to adjust to the increasing frequency of mid-career lateral transfers.

My thanks to Jim Cotterman and all other participants in this group discussion, including first-time contributors Philip Deitch, John Kleiser and Jeff Stevenson; recent article coauthor John Niehoff; and A&FP Board members Bill Brennan, Jim Davidson, Michael Mooney, Stephen M. (Pete) Peterson, and Ron Seigneur.

As I've learned to expect, all discussants provided unique perspectives and fresh insights. One line of thought, however ' Jeff Stevenson's ' was so distinctive that I've consolidated his views (and comments thereon) in an accompanying interview article. [See "Unfunded Plans: A More Upbeat View"]

1. What are the challenges of traditional unfunded programs?

Michael Mooney (Managing Partner, Nutter McClennen & Fish, LLP, [email protected]): It seems to me that the principal challenge of the traditional unfunded program is to limit a firm's exposure to the obligation it generates. It may not be a challenge for a program that provides very modest benefits, but any program that provides for the payment of any significant amounts can put a tremendous financial burden on the firm and can discourage younger partners, who feel they are feeding the older partners and retirees. Young partners have a tendency to expect they will never participate in the program ' not because the program will be discontinued, but because, like many view Social Security, they just expect it will not be there. Any firm that has an unfunded program that it has not brought under control faces a potential time bomb.

Ron Seigneur (Partner, Seigneur Gustafson Knight LLP CPAs, [email protected]): In the firms I work with, younger partners are not willing to have a portion of the firm's current earnings go toward satisfying unfunded retirement benefits for those no longer contributing to the success of the firm. The younger talent often talks with their feet. Recently I saw a firm in business over 60 years dissolve primarily because younger players left the firm to avoid paying an unfunded retirement benefit ' even though the benefit was capped at only 5% of the firm's distributable net income. The burden then became untenable for the remaining partners.

Bill Brennan (Principal, Altman Weil, Inc., bbrennan@altmanweil. com): This could become a serious concern for even large, prestigious law firms if they ignore the issue. Reducing profits available for distribution to the firm's active partners could cause the level of partner compensation to be substantially below market rates for comparably skilled and experienced lawyers.

Philip Deitch (Senior Manager, Human Resource Services, Price- waterhouseCoopers LLP, [email protected]): One reason the generational cross-subsidy in an unfunded plan may be meeting increased resistance is that in many firms it runs counter to the philosophy of other firm benefit programs (including defined-benefit pension programs), in which each partner pays for his or her own benefits.

Ron Seigneur: Another problem is that retiring partners often have an unrealistic expectation as to what their ownership interests should be redeemed at. Many partners retiring now have shared in the economic burden of substantial buyouts for the “blue sky” associated with the practice of previous retirees. With an “easy in/easy out” approach to capital now being a trend, however, firms can no longer justify the amounts previously paid for capital redemptions.

John Niehoff (CPA; Partner and head of Law Firm Services Group, Beers & Cutler, PLLC, [email protected]): Yes, many firms and plan participants seem to have trouble recognizing that unfunded retirement plans are only one piece of a multifaceted economic equation for a partner, which includes partner capital buy-in and buy-out, partner compensation and other benefits.

For instance: instead of dominating partner compensation, a founding senior partner may have deferred some immediate income in exchange for a retirement benefit years later. That and similar arrangements are fair, but unfunded plans based on them need to be modified as law firms mature and as they adapt to new competitive business environments.

Ron Seigneur: Yet another problem creating tremendous pressure on retirement benefits is that many firms are now mandating retirement earlier than ever ' at the same time that many individuals need to work longer to fund their retirement. The recent litigation at Sidley and Austin is indicative of this intersection of issues. Forcing out senior members at age 60, as happens in some of the Big 4 accounting firms, is a problematic way to create upward mobility for junior partners.

Pete Peterson (Maxfield Peterson, P.C., [email protected]): A related aspect of the mobility issue is that unfunded obligations increase the “free-agency partner” syndrome. Such partners feel no responsibility to support benefits for partners they hardly knew or worked with.

Because unfunded obligations create a significant future commitment of firm resources (to the extent that they threaten the overall stability of the firm), such plans also negatively impact lateral hiring and proposed mergers. Recently I teamed with another consultant to work on the proposed merger of two Midwest firms. My colleague, in writing about the firms' unfunded plans, had Freudian slips and typed 'unfounded' in each instance. Arguably 'unfounded' was the better choice of words! The merger fell through, and one of the primary drivers of concern was indeed the unfunded retirement plans. One of the firms decided to scrap its plan going forward.

Bill Brennan: We have also seen many instances of this problem in our merger practice. Unfunded retirement programs frequently become “deal-breaker” issues for law firm mergers because of the magnitude of the liabilities involved. Smaller law firms often merge in order to obtain increased financial security for their partners via diversification and access to greater resources. If a prospective acquirer has a substantial unfunded retirement liability, why would a small firm merge and assume that risk?

Philip Deitch: Regarding unfunded liabilities being an impediment to mergers: this is especially true for mergers with firms in non-US countries, where unfunded plans are less common.

Jim Davidson (Holland & Hart, LLP (Ret.), Consultant, [email protected]): The idea behind unfunded retirement programs predates the existence of qualified plans, or at least the ability to contribute much money to a qualified plan for high earners. Now that the ability to fund a qualified plan at a reasonable level is there, the unfunded programs have become obsolete in terms of a safety net for retiring partners.

That said, many unfunded plans continue to exist out of inertia and out of resistance to their discontinuance by those close to retirement age who have been counting on the program for their retirement income. The challenge I see here is of educating partners younger than the imminent retirees about the lack of sustainability of most of these programs. They are Ponzi schemes in this respect, just like Social Security. The founders, and maybe the generation following the founders, can cash out, but later comers will be left with bag in hand.

Lawyers are not economists for the most part. They didn't really stop to think about how (and by whom) these programs would be funded for the future, when more and more people ' think baby boomers ' would reach retirement age at about the same time.

Michael Mooney: Then, if a firm does choose to eliminate or limit the program, the challenge becomes how to do so in a fair manner.

Jim Cotterman (Principal, Altman Weil, Inc., [email protected]): Yes, and getting all stakeholders to accept the fairness of a solution is no small challenge. Don't underestimate the emotion that discussions of this nature generate. To complicate matters, there are no independent objective voices among the people discussing it. Open discussion – regarding the program, market conditions, program analysis and projections, exploration of alternatives and how they affect each group (retirees, near-retirees, mid-career and younger partners) ' is essential to build a solution that will work. Otherwise, the cure could kill the patient as surely as the disease can.

2. What remedies exist to mitigate the challenges?

John Niehoff: At one extreme, a firm could choose to maximize capital retention by simply abolishing unfunded retirement plans and limiting a retiring partner's return to the cash basis of his or her capital account. At the other extreme, some firms continue to support an unfunded retirement benefit that greatly exceeds any estimated economic contribution provided by the partner. The latter extreme is an albatross to firm continuity.

Unfortunately, firms often find it difficult to strike a balance between these two extremes. One balancing alternative is to limit the present value of cumulative retirement payments to a reasonable and discounted valuation of fees receivable (at the retirement date) that the retiring partner participated in generating.

Unfunded plans with payments for life or payments for multiple years based on past service are just the types of plans that must be modified; otherwise, they will either bring the firm down or at some point have to be drastically cut in a manner that will not sit well with current or former partners.

Jim Davidson: Those nearing retirement also have to be dealt with. In most law firms, some sort of consensus has to be reached on an issue as momentous as this in order to keep the firm together and deal fairly with those over, say, age 50 ' much like W is proposing with Social Security.

By way of history, our firm changed its unfunded plan in 1989 to:

• Cap the benefit based on pre-retirement comp;
• Limit the payout to 5 years rather than for life; and
• Cut out plan participation for partners who were young enough to build a reasonable retirement benefit using our qualified plans.

We also developed a set-aside program (after tax) to partially fund the program, so that those who would receive benefits from it would assist in paying for it.

Of the 36 people who were grandfathered (ie, who would receive a payment from the unfunded plan on retirement), eight had not retired as of 15 years later. Even though we had one year when six people retired simultaneously, the total payments were always manageable as a percentage of firm earnings. Given our projections for the remaining eight, payments will continue to be manageable absent some calamitous event.

Other firms might well draw different but equally valid conclusions. Important points to consider are the flexibility provided by qualified plans and the wide range of possibilities of who gets included or excluded from the unfunded plan.

• Even for over-50 partners, any unfunded program may need modification, depending on the group's size and the program's generosity. Total benefits and the total paid in any one year should both be capped.
• For those below the cutoff age, who have time to build a nest egg under a qualified plan, there is more flexibility: from the extreme of going totally cold turkey (cutting off benefits under the unfunded program entirely) to a phase-out with progressively less benefits the younger the partner.
• Given the ability to provide a reasonable retirement benefit using qualified plans, partners newly admitted should not be part of the unfunded plan at all.

Michael Mooney: Here's a brief description of how my own firm has sought to get unfunded obligations under control. We had already adopted an HR-10 (Keogh) Plan back in 1976 to provide qualified retirement benefits for our partners, and we decided in the early 1990s that it was time to phase out unfunded obligations altogether. Our partnership agreement at the time required unanimity to amend, so it took us 3 years to come up with a solution that all agreed was fair to everyone. Ultimately, though, we took four steps to limit the firm's exposure:

• We ceased benefit accruals under the program: a partner's two highest-earning years before 1994 were locked in as the base for the benefit. (For a first-year partner, his or her first-year compensation was simply doubled.)
• We blocked entry to the unfunded program for new partners elected after the cutoff date.
• Previously, partners leaving the firm after 15 years could receive “retirement” payments immediately. We changed that to defer normal commencement of the benefit until the later of age 65 or actual retirement as a partner. (In case of death, the benefit to the estate would begin at once.) This change reduced significantly the net present value of the firm's obligation.
• For current participants, we retained fractional vesting over a 15-year term and also built in some modest transitional rules.

(One step the partners considered but did not take was to have the unfunded plan benefit gradually decrease as the value of a partner's HR-10 account approached a defined target.)

The four steps taken by the firm mitigated the challenge significantly and brought certainty to a program that previously had unpredictable elements and ramifications. Had we not capped the program in 1994, our liability today would be enormous, due to the significant increases in partner compensation over the last decade.

Jim Davidson: A somewhat different concern relates to laterals admitted in mid-career. They would come into the firm and help pay for the unfunded program through lower income as benefits are paid from current income to retirees. They could be admitted to the program, although that could become expensive depending on their age at admission. They could receive a supplemental compensation benefit (a guaranteed payment in a partnership context) designed to offset, at least in large part, the lower income they would receive because of retirement payments. There are probably other solutions. I think it's important that the firm develop a policy on low to deal with laterals at the time the unfunded plan is modified, and that all laterals then be dealt with under that policy. They would become part of the qualified plans of the firm as soon as they met the eligibility requirements of the plan, and it would be difficult to exclude them from that under the law.

Jim Cotterman: The policy discussions Jim Davidson advocates [above and in his prior remarks] should be initiated sooner rather than later. As with the ongoing debates over Social Security and Medicare, time is working against us. Resistance to change will increase as more partners approach the period of receiving benefits ' all the while contributing more to the benefits of their predecessors. Corrective changes are also likely to be more costly when there is less time over which those changes can be implemented.

Pete Peterson: Firms should also carefully evaluate the effect of recent tax law changes on qualified plans. Some changes have made defined benefit plans more attractive due to higher benefit and compensation limits. [Editor's Note: A&FP articles on retirement plans have included major analyses in Nov.-Dec. 2003 (optimizing plans) and Dec. 2004 (tax-retirement issues), plus additional coverage of specific issues in Jan. 2005 (cash-out distributions) and Feb. 2005 (deferred payments).]

Philip Deitch: Here are a few additional suggestions:

• A firm's first step should be actuarial projection of plan costs, to anticipate the timing of future funding requirements and growth of unfunded liabilities.
• Shifting some of the benefits to a qualified defined benefit plan can provide tax advantages for both the partner and the firm, and provide benefit security to the partner. The qualified plan can be designed and managed effectively to eliminate downside volatility in contribution requirements, which is especially important in light of expected legislation this year on pension plan funding.
• To the extent the firm has a particularly good year, the firm can use cash to buy lump sums on a voluntary basis for retired partners. These partners would be willing to accept a “haircut,” or reduced value, in exchange for benefit security. Note that this approach has become more difficult with the new executive compensation rules (409A). On that note, the 409A rules further erode the advantages of unfunded plans (vs. qualified plans) by restricting the degree of flexibility.

3. Can a traditional unfunded program still work? If yes, what parameters create a “safe harbor”?

Ron Seigneur: No, firms must move away from unfunded commitments just as large corporate America has been doing (recent examples being the automotive sector and United Airlines). Recognizing commitments made to the senior group, however, firms should devise a tiered structure that gives participants time to replace unfunded benefits with funded benefit options.

Jim Davidson: Maybe I'm biased, but I find it hard to justify continuing an unfunded program in today's environment with so much movement of partners from firm to firm. It'd be a definite downer to contemplate joining a firm where I faced an unknowable liability to fund retirements of older participants ' especially since I might not get any benefit from the plan myself. I say unknowable not only because of the mobility factor but also because of potential future mergers with firms having older partners.

Michael Mooney: If I were starting afresh today, I would not implement an unfunded program at all. Frankly, I see no need for the program with the availability of qualified plans. My only caveat to this is that, when a firm provides qualified plan benefits to partners, it must provide “comparable” benefits to all staff of the firm (although these comparable benefits may be in a different form). Given this associated expense, the amount most firms are willing to contribute to partners is not unlimited.

John Niehoff: If benefits to retiring partners are too great, the firm will ultimately be forced into: a) curtailing benefits; or b) dissolving to see what each partner really gets. Many firms will learn to their dismay that the costs of winding down operations and dissolving a law firm often leave little left over for the benefit of remaining partners.

Bill Brennan: Generally it is good advice for firms to avoid adopting unfunded plans, and for firms that have them to start phasing them out. There are, however, rare situations where such plans not only work but are required to fairly compensate firm owners for the value they create.

The only “safe harbor” is for payments to be affordable at the time they are made. This is generally accomplished by limiting the payout in any given year to a certain percentage of the firm's profits, such as 5%. It is essential for payouts to be limited in this manner.

4. What effect will the approaching retirement of the baby boomer generation have on unfunded plans?

Jim Davidson: This is when the Ponzi scheme explodes.

Ron Seigneur: It is already starting to show. As the baby boomer bubble begins to threaten Social Security in the next several years, it will likewise threaten firms with unfunded retirement plans, especially uncapped plans. The moment the compensation of those still working drops below that of their peers, look out!

Philip Deitch: As the ratio of active partners to retired partners decreases, many firms will have to choose between much higher costs and reduced benefits. Also, talent recruitment and retention needs will require firms to retool their plans to provide more flexible retirement plans with the opportunity for significant tax deferrals.

Pete Peterson: From a personal planning perspective, I would not count on receiving unfunded benefits post retirement. The mega-accounting firm Arthur Andersen had an unfunded program, and their retirees no longer have this supplemental pension. These programs can only survive in firms with continued revenue and profit growth. Let's not forget the old adage from Peter Drucker: “For whom the gods would destroy, they first grant 40 years of business success.” Unforeseen outside events combined with poor decision making can bankrupt even the most successful firm.

Michael Mooney: If a firm has not already taken steps to limit its exposure under an unfunded plan, the retirement of the baby boomer generation could exert great stress on the firm's finances. New, younger partners are not going to sit by and watch a larger share of their earnings go to support retiring partners they hardly know.

What this also may do is force firms to encourage less productive partners, who should retire, to stay with the firm longer simply because the firm finds it easier to pay them some compensation for some production than make significant retirement payments for no production. That is a catch 22.

Unfunded Obligations: Related Resources

Passing the Baton

For an incisive exploration of organizational issues that interrelate with retirement planning, see Jim Cotterman's recent article “The Passing of the Baton.” Published by Altman Weil, Inc., the article is freely available for Web viewing at www.altmanweil.com/about/articles/pdf/PassingBatonJDC.pdf.

2005 Survey Data

Altman Weil also recently published the 2005 edition of its Retirement and Withdrawal Survey for Private Law Firms. Jim Cotterman authored the survey report's highly substantive introduction. The full report is available for purchase from Altman Weil (http://www.altmanweil.com/ or 610-886-2000).

Editor's Introduction

As summarized by A&FP Board member Bill Brennan of Altman Weil, Inc. an “unfunded retirement program” is essentially a promise to pay partners a retirement benefit in the future from the firm's future profits. About 24% of law firms have an unfunded retirement plan (down from 57% in 1990), according to the 2005 Retirement and Withdrawal Survey for Private Law Firms, prepared by Altman Weil, Inc. In about 15 years over 30,000 lawyers will be retiring each year. To the extent these partners must be paid retirement benefits from the then-current profits of their respective law firms, those firms unprepared for this potentially huge financial liability will be at risk, and some may not survive.

Former A&FP Board member Jim Cotterman, also of Altman Weil, has done some new writing about retirement plans recently [see "Related Resources"]. Jim also suggested the four questions around which this virtual-roundtable discussion was organized:

1. What are the challenges of traditional unfunded programs?
2. What remedies exist to mitigate the challenges?
3. Can a traditional unfunded program still work? If yes, what parameters create a “safe harbor”?
4. What effect will the approaching retirement of the baby boomer generation have on unfunded plans?

Problems with unfunded retirement plans are currently big news in the general business world, so law firms struggling with their plans are certainly not in totally unique straits. Law firms do have some distinctive concerns, however. For example, many firms are organized under difficult-to-change partnership agreements, many have experienced soaring growth in baseline compensation, and many are finding it hard to adjust to the increasing frequency of mid-career lateral transfers.

My thanks to Jim Cotterman and all other participants in this group discussion, including first-time contributors Philip Deitch, John Kleiser and Jeff Stevenson; recent article coauthor John Niehoff; and A&FP Board members Bill Brennan, Jim Davidson, Michael Mooney, Stephen M. (Pete) Peterson, and Ron Seigneur.

As I've learned to expect, all discussants provided unique perspectives and fresh insights. One line of thought, however ' Jeff Stevenson's ' was so distinctive that I've consolidated his views (and comments thereon) in an accompanying interview article. [See "Unfunded Plans: A More Upbeat View"]

1. What are the challenges of traditional unfunded programs?

Michael Mooney (Managing Partner, Nutter McClennen & Fish, LLP, [email protected]): It seems to me that the principal challenge of the traditional unfunded program is to limit a firm's exposure to the obligation it generates. It may not be a challenge for a program that provides very modest benefits, but any program that provides for the payment of any significant amounts can put a tremendous financial burden on the firm and can discourage younger partners, who feel they are feeding the older partners and retirees. Young partners have a tendency to expect they will never participate in the program ' not because the program will be discontinued, but because, like many view Social Security, they just expect it will not be there. Any firm that has an unfunded program that it has not brought under control faces a potential time bomb.

Ron Seigneur (Partner, Seigneur Gustafson Knight LLP CPAs, [email protected]): In the firms I work with, younger partners are not willing to have a portion of the firm's current earnings go toward satisfying unfunded retirement benefits for those no longer contributing to the success of the firm. The younger talent often talks with their feet. Recently I saw a firm in business over 60 years dissolve primarily because younger players left the firm to avoid paying an unfunded retirement benefit ' even though the benefit was capped at only 5% of the firm's distributable net income. The burden then became untenable for the remaining partners.

Bill Brennan (Principal, Altman Weil, Inc., bbrennan@altmanweil. com): This could become a serious concern for even large, prestigious law firms if they ignore the issue. Reducing profits available for distribution to the firm's active partners could cause the level of partner compensation to be substantially below market rates for comparably skilled and experienced lawyers.

Philip Deitch (Senior Manager, Human Resource Services, Price- waterhouseCoopers LLP, [email protected]): One reason the generational cross-subsidy in an unfunded plan may be meeting increased resistance is that in many firms it runs counter to the philosophy of other firm benefit programs (including defined-benefit pension programs), in which each partner pays for his or her own benefits.

Ron Seigneur: Another problem is that retiring partners often have an unrealistic expectation as to what their ownership interests should be redeemed at. Many partners retiring now have shared in the economic burden of substantial buyouts for the “blue sky” associated with the practice of previous retirees. With an “easy in/easy out” approach to capital now being a trend, however, firms can no longer justify the amounts previously paid for capital redemptions.

John Niehoff (CPA; Partner and head of Law Firm Services Group, Beers & Cutler, PLLC, [email protected]): Yes, many firms and plan participants seem to have trouble recognizing that unfunded retirement plans are only one piece of a multifaceted economic equation for a partner, which includes partner capital buy-in and buy-out, partner compensation and other benefits.

For instance: instead of dominating partner compensation, a founding senior partner may have deferred some immediate income in exchange for a retirement benefit years later. That and similar arrangements are fair, but unfunded plans based on them need to be modified as law firms mature and as they adapt to new competitive business environments.

Ron Seigneur: Yet another problem creating tremendous pressure on retirement benefits is that many firms are now mandating retirement earlier than ever ' at the same time that many individuals need to work longer to fund their retirement. The recent litigation at Sidley and Austin is indicative of this intersection of issues. Forcing out senior members at age 60, as happens in some of the Big 4 accounting firms, is a problematic way to create upward mobility for junior partners.

Pete Peterson (Maxfield Peterson, P.C., [email protected]): A related aspect of the mobility issue is that unfunded obligations increase the “free-agency partner” syndrome. Such partners feel no responsibility to support benefits for partners they hardly knew or worked with.

Because unfunded obligations create a significant future commitment of firm resources (to the extent that they threaten the overall stability of the firm), such plans also negatively impact lateral hiring and proposed mergers. Recently I teamed with another consultant to work on the proposed merger of two Midwest firms. My colleague, in writing about the firms' unfunded plans, had Freudian slips and typed 'unfounded' in each instance. Arguably 'unfounded' was the better choice of words! The merger fell through, and one of the primary drivers of concern was indeed the unfunded retirement plans. One of the firms decided to scrap its plan going forward.

Bill Brennan: We have also seen many instances of this problem in our merger practice. Unfunded retirement programs frequently become “deal-breaker” issues for law firm mergers because of the magnitude of the liabilities involved. Smaller law firms often merge in order to obtain increased financial security for their partners via diversification and access to greater resources. If a prospective acquirer has a substantial unfunded retirement liability, why would a small firm merge and assume that risk?

Philip Deitch: Regarding unfunded liabilities being an impediment to mergers: this is especially true for mergers with firms in non-US countries, where unfunded plans are less common.

Jim Davidson (Holland & Hart, LLP (Ret.), Consultant, [email protected]): The idea behind unfunded retirement programs predates the existence of qualified plans, or at least the ability to contribute much money to a qualified plan for high earners. Now that the ability to fund a qualified plan at a reasonable level is there, the unfunded programs have become obsolete in terms of a safety net for retiring partners.

That said, many unfunded plans continue to exist out of inertia and out of resistance to their discontinuance by those close to retirement age who have been counting on the program for their retirement income. The challenge I see here is of educating partners younger than the imminent retirees about the lack of sustainability of most of these programs. They are Ponzi schemes in this respect, just like Social Security. The founders, and maybe the generation following the founders, can cash out, but later comers will be left with bag in hand.

Lawyers are not economists for the most part. They didn't really stop to think about how (and by whom) these programs would be funded for the future, when more and more people ' think baby boomers ' would reach retirement age at about the same time.

Michael Mooney: Then, if a firm does choose to eliminate or limit the program, the challenge becomes how to do so in a fair manner.

Jim Cotterman (Principal, Altman Weil, Inc., [email protected]): Yes, and getting all stakeholders to accept the fairness of a solution is no small challenge. Don't underestimate the emotion that discussions of this nature generate. To complicate matters, there are no independent objective voices among the people discussing it. Open discussion – regarding the program, market conditions, program analysis and projections, exploration of alternatives and how they affect each group (retirees, near-retirees, mid-career and younger partners) ' is essential to build a solution that will work. Otherwise, the cure could kill the patient as surely as the disease can.

2. What remedies exist to mitigate the challenges?

John Niehoff: At one extreme, a firm could choose to maximize capital retention by simply abolishing unfunded retirement plans and limiting a retiring partner's return to the cash basis of his or her capital account. At the other extreme, some firms continue to support an unfunded retirement benefit that greatly exceeds any estimated economic contribution provided by the partner. The latter extreme is an albatross to firm continuity.

Unfortunately, firms often find it difficult to strike a balance between these two extremes. One balancing alternative is to limit the present value of cumulative retirement payments to a reasonable and discounted valuation of fees receivable (at the retirement date) that the retiring partner participated in generating.

Unfunded plans with payments for life or payments for multiple years based on past service are just the types of plans that must be modified; otherwise, they will either bring the firm down or at some point have to be drastically cut in a manner that will not sit well with current or former partners.

Jim Davidson: Those nearing retirement also have to be dealt with. In most law firms, some sort of consensus has to be reached on an issue as momentous as this in order to keep the firm together and deal fairly with those over, say, age 50 ' much like W is proposing with Social Security.

By way of history, our firm changed its unfunded plan in 1989 to:

• Cap the benefit based on pre-retirement comp;
• Limit the payout to 5 years rather than for life; and
• Cut out plan participation for partners who were young enough to build a reasonable retirement benefit using our qualified plans.

We also developed a set-aside program (after tax) to partially fund the program, so that those who would receive benefits from it would assist in paying for it.

Of the 36 people who were grandfathered (ie, who would receive a payment from the unfunded plan on retirement), eight had not retired as of 15 years later. Even though we had one year when six people retired simultaneously, the total payments were always manageable as a percentage of firm earnings. Given our projections for the remaining eight, payments will continue to be manageable absent some calamitous event.

Other firms might well draw different but equally valid conclusions. Important points to consider are the flexibility provided by qualified plans and the wide range of possibilities of who gets included or excluded from the unfunded plan.

• Even for over-50 partners, any unfunded program may need modification, depending on the group's size and the program's generosity. Total benefits and the total paid in any one year should both be capped.
• For those below the cutoff age, who have time to build a nest egg under a qualified plan, there is more flexibility: from the extreme of going totally cold turkey (cutting off benefits under the unfunded program entirely) to a phase-out with progressively less benefits the younger the partner.
• Given the ability to provide a reasonable retirement benefit using qualified plans, partners newly admitted should not be part of the unfunded plan at all.

Michael Mooney: Here's a brief description of how my own firm has sought to get unfunded obligations under control. We had already adopted an HR-10 (Keogh) Plan back in 1976 to provide qualified retirement benefits for our partners, and we decided in the early 1990s that it was time to phase out unfunded obligations altogether. Our partnership agreement at the time required unanimity to amend, so it took us 3 years to come up with a solution that all agreed was fair to everyone. Ultimately, though, we took four steps to limit the firm's exposure:

• We ceased benefit accruals under the program: a partner's two highest-earning years before 1994 were locked in as the base for the benefit. (For a first-year partner, his or her first-year compensation was simply doubled.)
• We blocked entry to the unfunded program for new partners elected after the cutoff date.
• Previously, partners leaving the firm after 15 years could receive “retirement” payments immediately. We changed that to defer normal commencement of the benefit until the later of age 65 or actual retirement as a partner. (In case of death, the benefit to the estate would begin at once.) This change reduced significantly the net present value of the firm's obligation.
• For current participants, we retained fractional vesting over a 15-year term and also built in some modest transitional rules.

(One step the partners considered but did not take was to have the unfunded plan benefit gradually decrease as the value of a partner's HR-10 account approached a defined target.)

The four steps taken by the firm mitigated the challenge significantly and brought certainty to a program that previously had unpredictable elements and ramifications. Had we not capped the program in 1994, our liability today would be enormous, due to the significant increases in partner compensation over the last decade.

Jim Davidson: A somewhat different concern relates to laterals admitted in mid-career. They would come into the firm and help pay for the unfunded program through lower income as benefits are paid from current income to retirees. They could be admitted to the program, although that could become expensive depending on their age at admission. They could receive a supplemental compensation benefit (a guaranteed payment in a partnership context) designed to offset, at least in large part, the lower income they would receive because of retirement payments. There are probably other solutions. I think it's important that the firm develop a policy on low to deal with laterals at the time the unfunded plan is modified, and that all laterals then be dealt with under that policy. They would become part of the qualified plans of the firm as soon as they met the eligibility requirements of the plan, and it would be difficult to exclude them from that under the law.

Jim Cotterman: The policy discussions Jim Davidson advocates [above and in his prior remarks] should be initiated sooner rather than later. As with the ongoing debates over Social Security and Medicare, time is working against us. Resistance to change will increase as more partners approach the period of receiving benefits ' all the while contributing more to the benefits of their predecessors. Corrective changes are also likely to be more costly when there is less time over which those changes can be implemented.

Pete Peterson: Firms should also carefully evaluate the effect of recent tax law changes on qualified plans. Some changes have made defined benefit plans more attractive due to higher benefit and compensation limits. [Editor's Note: A&FP articles on retirement plans have included major analyses in Nov.-Dec. 2003 (optimizing plans) and Dec. 2004 (tax-retirement issues), plus additional coverage of specific issues in Jan. 2005 (cash-out distributions) and Feb. 2005 (deferred payments).]

Philip Deitch: Here are a few additional suggestions:

• A firm's first step should be actuarial projection of plan costs, to anticipate the timing of future funding requirements and growth of unfunded liabilities.
• Shifting some of the benefits to a qualified defined benefit plan can provide tax advantages for both the partner and the firm, and provide benefit security to the partner. The qualified plan can be designed and managed effectively to eliminate downside volatility in contribution requirements, which is especially important in light of expected legislation this year on pension plan funding.
• To the extent the firm has a particularly good year, the firm can use cash to buy lump sums on a voluntary basis for retired partners. These partners would be willing to accept a “haircut,” or reduced value, in exchange for benefit security. Note that this approach has become more difficult with the new executive compensation rules (409A). On that note, the 409A rules further erode the advantages of unfunded plans (vs. qualified plans) by restricting the degree of flexibility.

3. Can a traditional unfunded program still work? If yes, what parameters create a “safe harbor”?

Ron Seigneur: No, firms must move away from unfunded commitments just as large corporate America has been doing (recent examples being the automotive sector and United Airlines). Recognizing commitments made to the senior group, however, firms should devise a tiered structure that gives participants time to replace unfunded benefits with funded benefit options.

Jim Davidson: Maybe I'm biased, but I find it hard to justify continuing an unfunded program in today's environment with so much movement of partners from firm to firm. It'd be a definite downer to contemplate joining a firm where I faced an unknowable liability to fund retirements of older participants ' especially since I might not get any benefit from the plan myself. I say unknowable not only because of the mobility factor but also because of potential future mergers with firms having older partners.

Michael Mooney: If I were starting afresh today, I would not implement an unfunded program at all. Frankly, I see no need for the program with the availability of qualified plans. My only caveat to this is that, when a firm provides qualified plan benefits to partners, it must provide “comparable” benefits to all staff of the firm (although these comparable benefits may be in a different form). Given this associated expense, the amount most firms are willing to contribute to partners is not unlimited.

John Niehoff: If benefits to retiring partners are too great, the firm will ultimately be forced into: a) curtailing benefits; or b) dissolving to see what each partner really gets. Many firms will learn to their dismay that the costs of winding down operations and dissolving a law firm often leave little left over for the benefit of remaining partners.

Bill Brennan: Generally it is good advice for firms to avoid adopting unfunded plans, and for firms that have them to start phasing them out. There are, however, rare situations where such plans not only work but are required to fairly compensate firm owners for the value they create.

The only “safe harbor” is for payments to be affordable at the time they are made. This is generally accomplished by limiting the payout in any given year to a certain percentage of the firm's profits, such as 5%. It is essential for payouts to be limited in this manner.

4. What effect will the approaching retirement of the baby boomer generation have on unfunded plans?

Jim Davidson: This is when the Ponzi scheme explodes.

Ron Seigneur: It is already starting to show. As the baby boomer bubble begins to threaten Social Security in the next several years, it will likewise threaten firms with unfunded retirement plans, especially uncapped plans. The moment the compensation of those still working drops below that of their peers, look out!

Philip Deitch: As the ratio of active partners to retired partners decreases, many firms will have to choose between much higher costs and reduced benefits. Also, talent recruitment and retention needs will require firms to retool their plans to provide more flexible retirement plans with the opportunity for significant tax deferrals.

Pete Peterson: From a personal planning perspective, I would not count on receiving unfunded benefits post retirement. The mega-accounting firm Arthur Andersen had an unfunded program, and their retirees no longer have this supplemental pension. These programs can only survive in firms with continued revenue and profit growth. Let's not forget the old adage from Peter Drucker: “For whom the gods would destroy, they first grant 40 years of business success.” Unforeseen outside events combined with poor decision making can bankrupt even the most successful firm.

Michael Mooney: If a firm has not already taken steps to limit its exposure under an unfunded plan, the retirement of the baby boomer generation could exert great stress on the firm's finances. New, younger partners are not going to sit by and watch a larger share of their earnings go to support retiring partners they hardly know.

What this also may do is force firms to encourage less productive partners, who should retire, to stay with the firm longer simply because the firm finds it easier to pay them some compensation for some production than make significant retirement payments for no production. That is a catch 22.

Unfunded Obligations: Related Resources

Passing the Baton

For an incisive exploration of organizational issues that interrelate with retirement planning, see Jim Cotterman's recent article “The Passing of the Baton.” Published by Altman Weil, Inc., the article is freely available for Web viewing at www.altmanweil.com/about/articles/pdf/PassingBatonJDC.pdf.

2005 Survey Data

Altman Weil also recently published the 2005 edition of its Retirement and Withdrawal Survey for Private Law Firms. Jim Cotterman authored the survey report's highly substantive introduction. The full report is available for purchase from Altman Weil (http://www.altmanweil.com/ or 610-886-2000).