Unfunded Plans: A More Upbeat View

Readers of the accompanying roundtable discussion may find themselves wondering if there's currently anything good to say about unfunded retirement plan obligations. About the only glimmer of hope was the allusion by one discussant (Bill Brennan) to “rare situations” where such plans might be required.

Here to speak up for such exceptional situations is Jeff Stevenson, Managing Director of Chicago Consulting Actuaries ([email protected]). Jeff's original answers to our four roundtable questions are interleaved with several follow-up questions and answers.

1. What are the challenges of traditional unfunded programs?

Jeff Stevenson: The problem today is that firms don't view these plans as much more than extra retirement income for partners. Accordingly, it is easy to draw the conclusion that unfunded plans don't make any sense. However, if a plan is viewed as a means of passing along equity growth in the firm, then the plan can be viewed differently.

Generally speaking, these plans are viewed as supplemental retirement benefits, much as they would be in a corporate situation. While this is certainly one purpose of these plans, there are other reasons that may still justify their existence. Some of the primary drivers for firms to establish an unfunded plan have been to provide:

• A means for “buying” a departing partner's business;
• A vehicle to restrict competition; and
• A reward for contributing to the development of the firm's overall value.

These objectives still exist, and a properly structured unfunded plan can still achieve each objective. Some would in fact argue that as growing law firms become less personal and more institutional, the need to provide a layer of institutional benefit will increase.

Perhaps the problem with many unfunded plans is that the structure of the plan was not properly designed to meet these goals; so as firms have grown, the plans have run wild, and a little pruning is now needed.

Editor: Could you elaborate on the notion of buying a departing partner's business?

If you were to go back to the early days of unfunded plans, you would find that the motivating reason for them was not purely retirement. True, the ability to defer income on a tax effective basis (ie, within qualified plans) was not the same as it is today; but I believe the overriding reason why these plans were established was to provide an “equity” distribution to partners as they depart the firm.

Think about how law firm practices get passed down to the next generation. They aren't sold (unless the firm is very small); instead the partner leaves the firm and hands over his/her book of business. What does the partner get in return?

If the partner owned part of a corporation instead of a partnership, this ownership would likely be represented as stock in the business. As his/her efforts built the business, the value of the shares would increase. At retirement these shares could be sold back to the business (or to fellow stockholders) to reap the appreciation of the shares ' corresponding to the increased value of the business that s/he helped create. This type of equity accumulation doesn't exist in a law partnership; ie, return of capital to a partner typically does not reflect market appreciation. Lawyers work hard to build up successful and thriving practices. While they may be well compensated for their labor they are not, arguably, compensated at all for the goodwill and value creation they have contributed towards their firm institutionally.

This is one rationale for the nonqualified plan. It is a way to allow the departing partner to “cash in” on their contribution to the growth of the firm and the “book of business” they are leaving behind.

2. What remedies exist to mitigate the challenges?

Jeff Stevenson: My general rule of thumb is that the annual payouts should never exceed 2 to 3% of partner distributable income. If the plan can achieve this fiscal objective, then the plan can add tremendous value to the firm in terms of partner transition and competitive restrictions. If obligations exceed this level, the dangers detailed in our group discussion can arise. So the first step for any firm to take is an aggressive financial review of their plan.

Second, the firm must define its stated objectives for the plan. Is it to provide retirement income, or is it broader than that? If the primary goal is retirement income, then I agree that the plan should be eliminated. There are sufficient ways for partners to provide for retirement without adding this burden to the firm.

However, if the task is to provide payment for a partner's business, or to prevent competition, or to reward one for a long career, then these plans still have value. The question then must be asked, does our plan achieve these results? If not, then the plan should be redesigned.

There are two design features that I think are important in an efficient program. First, the payment to the retired partner should be for a fixed period. Second, the actual payments to the retired partner should be linked to the success of the firm during the payout period. That is, if the firm does well after the partner retires, the partner's payment should reflect that success. Likewise, if the firm struggles and partner share value declines, the retired partner's payment should also decline. These are not features commonly found in unfunded plans today, but are important to maintain a healthy program.

Editor: How does an unfunded retirement plan serve as a vehicle to restrict competition?

Jeff Stevenson: In most situations it is both a carrot and a stick. The carrot is “if you are a good person and you stay with us until retirement, we will give you a nice payout.” The stick is “if you leave the firm and then compete against us, you will lose that nice payout (even if it has already commenced).” It is much more difficult to hire a lateral partner who has accrued a large forfeitable benefit at his current firm.

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

Jeff Stevenson: Sure, I think they can still work, but the purpose of the plan needs to be clearly defined and the structure and design of the plan need to tie back to these key objectives. Firms may need to think outside the box in terms of design because the plan is not a retirement plan as much as a transfer of wealth or value from one generation to the next, and the payout of a portion of the firm's goodwill to those who helped create it.

If the plan is a “restriction” or “handcuff,” then this restriction or handcuff surely has some value (as opposed to letting the partner take his practice wherever he wants). Also, having a plan in place will encourage each partner to transition accounts and relationships to other people in the firm without the fear of being shortchanged at retirement.

Regardless of its purposes, any unfunded plan needs periodic monitoring to ensure that the original goals of the plan remain valid and that the plan continues to accomplish those goals.

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

Jeff Stevenson: Yes, plans in place today will see heartburn as the number of retirees increase by baby boomer retirement. However, for firms that continue to grow and that have restructured their plan to accomplish objectives other than providing mere retirement benefits, the baby boomer retirement in and of itself should not be a big deal. Firms that construct their plans to focus on these key goals will constructively pass on the tremendous value created by the baby boomer generation, greatly benefiting their GenX successors.

Follow-up Discussion

Ron Seigneur: This is an excellent complement to our main line of discussion. Jeff Stevenson argues correctly that unfunded plans should be viewed as a return of accumulated value and not merely as a retirement entitlement. He's also right to recommend time-limiting the firm's obligation and adjusting payments up or down based on the success of what the retiree passes on.

Jim Davidson: Regarding any payout for “goodwill”: I read that to be the value of receivables and inventory not included in tangible capital. But a partner's share of such goodwill at the date of retirement isn't the whole answer; what about receivables and inventory the firm already had when the partner was admitted, albeit years ago? If the retiring partner already shared in the liquidation of that “goodwill,” then only the increment, adjusted for inflation, represents his or her contribution ' not an easy amount to determine.

John Kleiser (for travelling Jeff Stevenson; [email protected]): Actually Jeff meant “goodwill” in its intangible sense, as representing the overall favorable attitude of a partner's clients towards the firm. Partners who nurture and leave behind such “goodwill” feel entitled to some ongoing compensation for it.

Jim Cotterman: Historically, leaving a law firm meant retirement, death or disability; so unfunded plans did have parallel and often indistinguishable elements of retirement and buy-out. With mid-career departures now frequent, we still need to consider both elements, but we must keep them analytically distinct. For example, adjusting the design of an unfunded plan to restrict post-retirement competition by a partner differs greatly from planning a general buy-out of the partner's interest.

It is also important to recall that professional services firms are valued differently from other businesses. Even legal and accounting practices, which have many similarities, are valued differently.

When a partner “hands over” his or her book of business, we should give due regard to the complexity of client retention in a professional services firm. A successful transfer requires the concurrence and future effective cooperation of both the ongoing or beneficiary lawyer and the client. Due to the considerable uncertainty that handed-over business will stay with the firm, the value of a departing lawyer's book of business must be adjusted downward ' and more so than lawyers might like to think.

Remember also that lawyers take “equity interest” out of the firm annually. It will be interesting to watch developments in the UK, where law firms will soon be testing the equity markets. Based on my M&A experience with health care providers back in the 1980s, I anticipate difficulties once law partners realize they need to reduce their current compensation if investors are to get a return on their investments.

Finally, in helping firms design programs to reward retirees for the value they leave behind, I stress that such plans must rationally look at the entirety of the economic relationship between a partner and the firm ' including buy-in, capital formation, annual compensation, annual retirement funding, buy-out and these unfunded programs. All these components should work together and make sense relative to each other. Often they don't, and that exacerbates the issues we've been discussing.

John Kleiser (for Jeff Stevenson): We absolutely agree. This complexity is what needs to be incorporated into the design of a successful nonqualified program. Tying a partner's payments to the future success of the firm, and specifically to the ongoing success of client relationships the partner has helped the firm retain, is crucial to the success of the program.

Readers of the accompanying roundtable discussion may find themselves wondering if there's currently anything good to say about unfunded retirement plan obligations. About the only glimmer of hope was the allusion by one discussant (Bill Brennan) to “rare situations” where such plans might be required.

Here to speak up for such exceptional situations is Jeff Stevenson, Managing Director of Chicago Consulting Actuaries ([email protected]). Jeff's original answers to our four roundtable questions are interleaved with several follow-up questions and answers.

1. What are the challenges of traditional unfunded programs?

Jeff Stevenson: The problem today is that firms don't view these plans as much more than extra retirement income for partners. Accordingly, it is easy to draw the conclusion that unfunded plans don't make any sense. However, if a plan is viewed as a means of passing along equity growth in the firm, then the plan can be viewed differently.

Generally speaking, these plans are viewed as supplemental retirement benefits, much as they would be in a corporate situation. While this is certainly one purpose of these plans, there are other reasons that may still justify their existence. Some of the primary drivers for firms to establish an unfunded plan have been to provide:

• A means for “buying” a departing partner's business;
• A vehicle to restrict competition; and
• A reward for contributing to the development of the firm's overall value.

These objectives still exist, and a properly structured unfunded plan can still achieve each objective. Some would in fact argue that as growing law firms become less personal and more institutional, the need to provide a layer of institutional benefit will increase.

Perhaps the problem with many unfunded plans is that the structure of the plan was not properly designed to meet these goals; so as firms have grown, the plans have run wild, and a little pruning is now needed.

Editor: Could you elaborate on the notion of buying a departing partner's business?

If you were to go back to the early days of unfunded plans, you would find that the motivating reason for them was not purely retirement. True, the ability to defer income on a tax effective basis (ie, within qualified plans) was not the same as it is today; but I believe the overriding reason why these plans were established was to provide an “equity” distribution to partners as they depart the firm.

Think about how law firm practices get passed down to the next generation. They aren't sold (unless the firm is very small); instead the partner leaves the firm and hands over his/her book of business. What does the partner get in return?

If the partner owned part of a corporation instead of a partnership, this ownership would likely be represented as stock in the business. As his/her efforts built the business, the value of the shares would increase. At retirement these shares could be sold back to the business (or to fellow stockholders) to reap the appreciation of the shares ' corresponding to the increased value of the business that s/he helped create. This type of equity accumulation doesn't exist in a law partnership; ie, return of capital to a partner typically does not reflect market appreciation. Lawyers work hard to build up successful and thriving practices. While they may be well compensated for their labor they are not, arguably, compensated at all for the goodwill and value creation they have contributed towards their firm institutionally.

This is one rationale for the nonqualified plan. It is a way to allow the departing partner to “cash in” on their contribution to the growth of the firm and the “book of business” they are leaving behind.

2. What remedies exist to mitigate the challenges?

Jeff Stevenson: My general rule of thumb is that the annual payouts should never exceed 2 to 3% of partner distributable income. If the plan can achieve this fiscal objective, then the plan can add tremendous value to the firm in terms of partner transition and competitive restrictions. If obligations exceed this level, the dangers detailed in our group discussion can arise. So the first step for any firm to take is an aggressive financial review of their plan.

Second, the firm must define its stated objectives for the plan. Is it to provide retirement income, or is it broader than that? If the primary goal is retirement income, then I agree that the plan should be eliminated. There are sufficient ways for partners to provide for retirement without adding this burden to the firm.

However, if the task is to provide payment for a partner's business, or to prevent competition, or to reward one for a long career, then these plans still have value. The question then must be asked, does our plan achieve these results? If not, then the plan should be redesigned.

There are two design features that I think are important in an efficient program. First, the payment to the retired partner should be for a fixed period. Second, the actual payments to the retired partner should be linked to the success of the firm during the payout period. That is, if the firm does well after the partner retires, the partner's payment should reflect that success. Likewise, if the firm struggles and partner share value declines, the retired partner's payment should also decline. These are not features commonly found in unfunded plans today, but are important to maintain a healthy program.

Editor: How does an unfunded retirement plan serve as a vehicle to restrict competition?

Jeff Stevenson: In most situations it is both a carrot and a stick. The carrot is “if you are a good person and you stay with us until retirement, we will give you a nice payout.” The stick is “if you leave the firm and then compete against us, you will lose that nice payout (even if it has already commenced).” It is much more difficult to hire a lateral partner who has accrued a large forfeitable benefit at his current firm.

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

Jeff Stevenson: Sure, I think they can still work, but the purpose of the plan needs to be clearly defined and the structure and design of the plan need to tie back to these key objectives. Firms may need to think outside the box in terms of design because the plan is not a retirement plan as much as a transfer of wealth or value from one generation to the next, and the payout of a portion of the firm's goodwill to those who helped create it.

If the plan is a “restriction” or “handcuff,” then this restriction or handcuff surely has some value (as opposed to letting the partner take his practice wherever he wants). Also, having a plan in place will encourage each partner to transition accounts and relationships to other people in the firm without the fear of being shortchanged at retirement.

Regardless of its purposes, any unfunded plan needs periodic monitoring to ensure that the original goals of the plan remain valid and that the plan continues to accomplish those goals.

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

Jeff Stevenson: Yes, plans in place today will see heartburn as the number of retirees increase by baby boomer retirement. However, for firms that continue to grow and that have restructured their plan to accomplish objectives other than providing mere retirement benefits, the baby boomer retirement in and of itself should not be a big deal. Firms that construct their plans to focus on these key goals will constructively pass on the tremendous value created by the baby boomer generation, greatly benefiting their GenX successors.

Follow-up Discussion

Ron Seigneur: This is an excellent complement to our main line of discussion. Jeff Stevenson argues correctly that unfunded plans should be viewed as a return of accumulated value and not merely as a retirement entitlement. He's also right to recommend time-limiting the firm's obligation and adjusting payments up or down based on the success of what the retiree passes on.

Jim Davidson: Regarding any payout for “goodwill”: I read that to be the value of receivables and inventory not included in tangible capital. But a partner's share of such goodwill at the date of retirement isn't the whole answer; what about receivables and inventory the firm already had when the partner was admitted, albeit years ago? If the retiring partner already shared in the liquidation of that “goodwill,” then only the increment, adjusted for inflation, represents his or her contribution ' not an easy amount to determine.

John Kleiser (for travelling Jeff Stevenson; [email protected]): Actually Jeff meant “goodwill” in its intangible sense, as representing the overall favorable attitude of a partner's clients towards the firm. Partners who nurture and leave behind such “goodwill” feel entitled to some ongoing compensation for it.

Jim Cotterman: Historically, leaving a law firm meant retirement, death or disability; so unfunded plans did have parallel and often indistinguishable elements of retirement and buy-out. With mid-career departures now frequent, we still need to consider both elements, but we must keep them analytically distinct. For example, adjusting the design of an unfunded plan to restrict post-retirement competition by a partner differs greatly from planning a general buy-out of the partner's interest.

It is also important to recall that professional services firms are valued differently from other businesses. Even legal and accounting practices, which have many similarities, are valued differently.

When a partner “hands over” his or her book of business, we should give due regard to the complexity of client retention in a professional services firm. A successful transfer requires the concurrence and future effective cooperation of both the ongoing or beneficiary lawyer and the client. Due to the considerable uncertainty that handed-over business will stay with the firm, the value of a departing lawyer's book of business must be adjusted downward ' and more so than lawyers might like to think.

Remember also that lawyers take “equity interest” out of the firm annually. It will be interesting to watch developments in the UK, where law firms will soon be testing the equity markets. Based on my M&A experience with health care providers back in the 1980s, I anticipate difficulties once law partners realize they need to reduce their current compensation if investors are to get a return on their investments.

Finally, in helping firms design programs to reward retirees for the value they leave behind, I stress that such plans must rationally look at the entirety of the economic relationship between a partner and the firm ' including buy-in, capital formation, annual compensation, annual retirement funding, buy-out and these unfunded programs. All these components should work together and make sense relative to each other. Often they don't, and that exacerbates the issues we've been discussing.

John Kleiser (for Jeff Stevenson): We absolutely agree. This complexity is what needs to be incorporated into the design of a successful nonqualified program. Tying a partner's payments to the future success of the firm, and specifically to the ongoing success of client relationships the partner has helped the firm retain, is crucial to the success of the program.