Unfunded Retirement Plans: An Ongoing Problem

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