Unfunded Retirement Plans: An Ongoing Problem

Over the years, we have worked with a number of firms to eliminate or limit their unfunded obligations. In almost all cases, the unfunded plan was either a significant financial burden or had the potential to become one. While the methods to curtail the liability are more or less unlimited, some common approaches have been used, including:

1) 'Cold Turkey' Solution: Merely stop the program and discontinue the benefit for all partners from a given date going forward.

a) One complication of this solution is that it may not be fair to those who are close to retirement, and who may have been counting on such funds as a source of retirement income. Over time, this is becoming less of an issue, as more partners are utilizing, and fully funding, qualified retirement plans.

b) For firms currently paying benefits to retired partners, such partners are typically grandfathered to avoid lawsuits and negative publicity.

c) This is often one of the most difficult, yet most equitable, means of solving unfunded retirement plans. The immediate suspension of benefits often results in those with the highest incomes (and who have paid the most into past benefits) getting the most significant increase in current income.

2) Grandfather Current Participants/Discontinue Future Program Participation: Grandfather all partners into the program, but discontinue the benefit for all future partners.

a) This solution can be a disincentive for younger partners and for laterals who may consider joining the firm. In particular, younger partners with strong, portable practices may be tempted to explore other career options if they are unhappy paying benefits to those partners who were grandfathered into the system, whereas they were not.

b) Many firms that utilize this solution will attempt to minimize the concerns of the future, nonparticipating partners by requiring an immediate commencement of funding at a reduced rate (e.g., the firm brackets a threshold of profits dedicated to paying benefits) to grandfathered partners, rather than waiting for retirement. This has the effect of reducing the ultimate burden of the benefit on future partners, and forcing grandfathered partners to bear some of the cost of their own benefit.

3) Grandfather Those Above a Threshold Age: Pick an age threshold at which everyone is grandfathered into the program (e.g., 55), and terminate the benefit for everyone currently below that age.

a) Many firms are tempted to perform an analysis of how much the past program has cost the current members, as a means of justifying the solutions. This may make the selection of an age threshold more acceptable. For example, if we find that most of the partners below the age of 55 have lost only minimal income due to the program, this may be an appropriate age threshold.

b) Some firms choose to utilize this option, and structure the benefit as a true Founders' Benefit, available only to those who took the extraordinary risks in starting the firm.

c) One problem with this solution is that it has the potential to encourage non-beneficiary partners to consider leaving the firm, since they will be paying for a benefit that they will not enjoy. Imposing a limitation of payments provision, which gives non-participants some security in limiting the impact on their current income, can minimize this threat.

4) Grandfather with Benefit Reduction: Grandfather all partners into the program, disallow participation for all future partners, and freeze the value of the benefit as of a set date.

a) Many firms utilizing this option will reduce the overall benefit at some fraction of the current value in order to minimize the objections of future partners (e.g., everyone gets 60% of current benefit value).

b) Some firms have chosen to give existing partners a proprietary interest in WIP and A/R in exchange for giving up some benefit (as a contingency in case the firm dissolves), thereby securing their retirement benefit.

5) Continue Program with Limitation of Payments Provision: Continue the unfunded plan with full benefits, but implement a low limitation of payments provision that applies to all beneficiaries equally.

a) Limit the maximum sum of all annual payments under the program to a fixed percentage (e.g., no more than 4% of distributable net income).

b) In any year where the sum of all payments meets or exceeds this payment limit, prorate payments to all beneficiaries, and all additional payments for the year are stopped and deferred to future years.

c) This is often one of the most successful, simple, and least costly solutions to unfunded retirement plans, although partners must understand that the likelihood of ever receiving a full benefit, or payment of a timely benefit of substance, diminishes if the firm's growth slows. However, the use of this option may prevent the firm from ever successfully pursuing a merger as a means to achieving its strategy, since a merger will likely require either the termination of this program or adoption of the plan by the merging firm.

6) Continue Program But Phase In Decreasing Limitation of Payments Provision: Under this solution, the firm keeps the underlying unfunded benefit in place, but over time the firm reduces the limitation of payment provision (e.g., transitioning from a cap of 5%, down to 1%).

a) Typically, those closest to retirement get the benefit of the existing cap (or in the case where there is no cap, no new cap is introduced), whereas every few years the cap is reduced by two percentage points, until at some point in the future the cap is frozen at 1%.

b) The advantage to this solution is that no one is forced to give up a benefit, but instead merely faces the potential that it will take longer to receive his or her full benefit.

Over the long term, this solution provides a gradual mechanism which conditions partners to the idea that the ultimate benefit is not that great, and increases the chance of simply stopping the program altogether at some future date once the cap is reduced to a minimal level.

7) Paper Dissolution: This solution entails a hypothetical dissolution of the firm, in which the existing partners extract their respective interests out of the firm, and then create a new firm by requiring a capital contribution (typically, an easy in/easy out cash basis capitalization system) to fund the new firm.

a) The benefit to this solution is that it gives partners a true means of determining the value of the firm, and forces them to confront the significant costs of starting and running a law firm.

b) This can be a dangerous and risky solution, in that some partners may receive a significant cash benefit from the firm, and choose not to be part of the startup operation.

Conclusion

Unfunded retirement plans continue to challenge and disrupt those firms that have them. Fortunately, it is possible to alter the plans and eliminate a long-term burden and liability. The seven options listed above are the most common methods for addressing unfunded retirement plans, although many minor variations are used.

This article originally appeared in Law Firm Partnership & Benefits Report, a sister publication of this newsletter.

Blane R. Prescott and William G. Johnston are consultants with
Hildebrandt International, a management consulting firm that specializes in the legal profession. Prescott is based in San Francisco and can be reached at [email protected]. Johnston is based in Newtown, CT, and can be reached at [email protected].

During the past year, we witnessed a marked increase in the number of law firms, both large and small, which are finding that their existing unfunded retirement plans are becoming significant, disruptive forces. The underlying problem created by these plans is that the plans result in current income being diverted to former partners, thereby reducing the compensation of the remaining active partners. Today, the combination of an expected spike in retirements related to the baby boom generation and, for many firms, greatly increased benefit exposure due to sharp increases in firm profitability that is factored into the value of retiree benefits, stand ready to test the financial viability of even the strongest firms.

In our experience, a reduction of current income may be acceptable only as long as the amount of the current income being diverted is modest (i.e., a limitation of payments provision pegged at not more than 4%-5% of total distributable net income), and the amount of remaining distributable income to the partners is at a level they perceive to be generally competitive with the market. If, however, the firm begins losing partners to competitors and/or to retirement, and the existing partners perceive they are diverting disproportionate current income to such former partners, the viability of the firm is frequently undermined. As the amount of income being diverted to former partners exceeds this threshold, current partners are motivated to:

• Assess whether the firm will survive long enough to pay them their retirement benefit, and if so, whether that benefit will be at a level they perceive to be fair given their historical sacrifices; and
• Assess whether leaving the firm may increase their current income and provide a better guarantee of retirement income. For example, a partner may be able to join another firm laterally and receive greater current income (due to the lack of an unfunded retirement program). In addition, the partner may be eligible to receive payments for his/ her unfunded retirement benefit by leaving the firm early. As a result, current income would be maximized, and such income is under immediate control as opposed to being contingent upon the survival of the firm and the willingness of future partners to pay the benefit.

Over the years, many firms proactively attacked their unfunded plans to avoid the financial challenge that others now face. More often than not, firms that altered their retirement plans did so in response to specific strategic challenges, including:

• A general concern about the firm's ability to fund the benefit when due;
• An inability to retain talented lawyers who departed the firm due, in part, to unhappiness about being forced to subsidize the retirement of former partners;
• Difficulty recruiting key laterals, many of whom left previous firms to get away from onerous unfunded retirement liabilities; and
• An inability to grow via merger due to the reluctance of the potential merger partner to join a firm that was bringing to the table an unfunded obligation.

One of the most common hurdles in addressing unfunded programs is that partners ultimately must give up a benefit, and there is no alternate source of funds available from which to replace this benefit. For less senior partners, the lost benefit may be more than offset by increased current income over their remaining careers. However, for more senior partners who have already foregone historical income and may now face the prospect of losing future benefits, the termination of the program can prompt them to sue the firm for promised benefits or call for the dissolution of the firm in order to realize some value from the firm. For these reasons, resolution of such programs is among the most difficult operational issues law firms confront.

Potential Solutions

Over the years, we have worked with a number of firms to eliminate or limit their unfunded obligations. In almost all cases, the unfunded plan was either a significant financial burden or had the potential to become one. While the methods to curtail the liability are more or less unlimited, some common approaches have been used, including:

1) 'Cold Turkey' Solution: Merely stop the program and discontinue the benefit for all partners from a given date going forward.

a) One complication of this solution is that it may not be fair to those who are close to retirement, and who may have been counting on such funds as a source of retirement income. Over time, this is becoming less of an issue, as more partners are utilizing, and fully funding, qualified retirement plans.

b) For firms currently paying benefits to retired partners, such partners are typically grandfathered to avoid lawsuits and negative publicity.

c) This is often one of the most difficult, yet most equitable, means of solving unfunded retirement plans. The immediate suspension of benefits often results in those with the highest incomes (and who have paid the most into past benefits) getting the most significant increase in current income.

2) Grandfather Current Participants/Discontinue Future Program Participation: Grandfather all partners into the program, but discontinue the benefit for all future partners.

a) This solution can be a disincentive for younger partners and for laterals who may consider joining the firm. In particular, younger partners with strong, portable practices may be tempted to explore other career options if they are unhappy paying benefits to those partners who were grandfathered into the system, whereas they were not.

b) Many firms that utilize this solution will attempt to minimize the concerns of the future, nonparticipating partners by requiring an immediate commencement of funding at a reduced rate (e.g., the firm brackets a threshold of profits dedicated to paying benefits) to grandfathered partners, rather than waiting for retirement. This has the effect of reducing the ultimate burden of the benefit on future partners, and forcing grandfathered partners to bear some of the cost of their own benefit.

3) Grandfather Those Above a Threshold Age: Pick an age threshold at which everyone is grandfathered into the program (e.g., 55), and terminate the benefit for everyone currently below that age.

a) Many firms are tempted to perform an analysis of how much the past program has cost the current members, as a means of justifying the solutions. This may make the selection of an age threshold more acceptable. For example, if we find that most of the partners below the age of 55 have lost only minimal income due to the program, this may be an appropriate age threshold.

b) Some firms choose to utilize this option, and structure the benefit as a true Founders' Benefit, available only to those who took the extraordinary risks in starting the firm.

c) One problem with this solution is that it has the potential to encourage non-beneficiary partners to consider leaving the firm, since they will be paying for a benefit that they will not enjoy. Imposing a limitation of payments provision, which gives non-participants some security in limiting the impact on their current income, can minimize this threat.

4) Grandfather with Benefit Reduction: Grandfather all partners into the program, disallow participation for all future partners, and freeze the value of the benefit as of a set date.

a) Many firms utilizing this option will reduce the overall benefit at some fraction of the current value in order to minimize the objections of future partners (e.g., everyone gets 60% of current benefit value).

b) Some firms have chosen to give existing partners a proprietary interest in WIP and A/R in exchange for giving up some benefit (as a contingency in case the firm dissolves), thereby securing their retirement benefit.

5) Continue Program with Limitation of Payments Provision: Continue the unfunded plan with full benefits, but implement a low limitation of payments provision that applies to all beneficiaries equally.

a) Limit the maximum sum of all annual payments under the program to a fixed percentage (e.g., no more than 4% of distributable net income).

b) In any year where the sum of all payments meets or exceeds this payment limit, prorate payments to all beneficiaries, and all additional payments for the year are stopped and deferred to future years.

c) This is often one of the most successful, simple, and least costly solutions to unfunded retirement plans, although partners must understand that the likelihood of ever receiving a full benefit, or payment of a timely benefit of substance, diminishes if the firm's growth slows. However, the use of this option may prevent the firm from ever successfully pursuing a merger as a means to achieving its strategy, since a merger will likely require either the termination of this program or adoption of the plan by the merging firm.

6) Continue Program But Phase In Decreasing Limitation of Payments Provision: Under this solution, the firm keeps the underlying unfunded benefit in place, but over time the firm reduces the limitation of payment provision (e.g., transitioning from a cap of 5%, down to 1%).

a) Typically, those closest to retirement get the benefit of the existing cap (or in the case where there is no cap, no new cap is introduced), whereas every few years the cap is reduced by two percentage points, until at some point in the future the cap is frozen at 1%.

b) The advantage to this solution is that no one is forced to give up a benefit, but instead merely faces the potential that it will take longer to receive his or her full benefit.

Over the long term, this solution provides a gradual mechanism which conditions partners to the idea that the ultimate benefit is not that great, and increases the chance of simply stopping the program altogether at some future date once the cap is reduced to a minimal level.

7) Paper Dissolution: This solution entails a hypothetical dissolution of the firm, in which the existing partners extract their respective interests out of the firm, and then create a new firm by requiring a capital contribution (typically, an easy in/easy out cash basis capitalization system) to fund the new firm.

a) The benefit to this solution is that it gives partners a true means of determining the value of the firm, and forces them to confront the significant costs of starting and running a law firm.

b) This can be a dangerous and risky solution, in that some partners may receive a significant cash benefit from the firm, and choose not to be part of the startup operation.

Conclusion

Unfunded retirement plans continue to challenge and disrupt those firms that have them. Fortunately, it is possible to alter the plans and eliminate a long-term burden and liability. The seven options listed above are the most common methods for addressing unfunded retirement plans, although many minor variations are used.

This article originally appeared in Law Firm Partnership & Benefits Report, a sister publication of this newsletter.

Blane R. Prescott and William G. Johnston are consultants with
Hildebrandt International, a management consulting firm that specializes in the legal profession. Prescott is based in San Francisco and can be reached at [email protected]. Johnston is based in Newtown, CT, and can be reached at [email protected].