It’s a safe bet that partners at Simpson Thacher & Bartlett aren’t lying awake at night worrying about their 401(k)s. No matter what happens to the stock market, they’re guaranteed to retire rich, thanks to the firm’s pension plan.

The plan—the most generous among 21 Am Law 100 pension plans we analyzed for this article—promises retired partners a quarter of the compensation they received during their highest-earning years. For life. On top of that, retirees receive an additional payout of 130 percent of that highest-compensation average, spread out over seven years. Currently, 30 retired Simpson partners are receiving these pension benefits.

Benefits under Simpson’s plan, like those of other Am Law 100 firms with traditional unfunded pension programs, are paid for out of current income. And because Simpson, like other Am Law 100 firms, has steadily expanded the size of its partnership since the plan was created, we wondered how much it will cost the firm over the next decade or so, as a glut of those it elevated to partner in the seventies and eighties retire.

The answer: a lot. Our hypothetical, back-of-the-envelope calculation of Simpson’s future liability—which we believe can stand in for at least a dozen similarly situated firms—indicates that it will be paying out of its annual income a minimum of roughly $65 million a year by 2022, double the estimated current annual payout. (We asked Simpson chairman Philip “Pete” Ruegger III to correct or comment on our numbers. He declined.)

A scan of the firm’s 194 partners reveals that approximately a quarter could be expected to retire by 2022, providing that most do so around the firm’s normal retirement age of 62. Assuming a handful die early, the firm may see 43 new full-freight retirees within the decade. Assuming that this batch of senior partners have been earning $3.5 million during their highest-compensated years—a conservative estimate, consultants say, at a firm that posted average profits per partner of $2.6 million in 2010—a soon-to-retire partner can expect roughly $875,000 a year in benefits, plus roughly $650,000 in each of the first seven years from the additional distribution (subtracting roughly $50,000 offset by another defined benefit plan funded by the firm). Over the decade, the firm’s annual liability gradually creeps up to roughly $65 million for the new retirees by 2022, not including benefits for those already in retirement. But as long as the firm increases its net by about 3–4 percent a year (since 2000, PPP has grown an average of 4.68 percent annually), the drag on profits will remain just about what it is now.

At Simpson and many other Am Law 200 firms, pensions are the elephant in the room. Several firms continue to guarantee their equity partners far richer pension plans than they probably should. And that future pension liability is growing at a time when it is looking less than certain that profits and partner head count will grow in step with them.

The recession, with its double whammy of retirement investment portfolio declines and firm revenue slowdowns, was a broad wake-up call for firms that fund pensions out of current income, as well as for the broader swath of firms that fund benefits out of firm-run investment portfolios. Many in the latter category had to dig into earnings to cover shortfalls in guaranteed benefits funded by firm investments. But the problems created by the sagging economy brought into relief a bigger, looming issue: The ranks of retired partners is swelling just as the number of equity partners—who are ultimately responsible for funding the pension plans—is leveling off. “This is an issue that cuts across all regions and all sizes of firms,” says Dan DiPietro, chair of the Law Firm Group of Citi Private Bank. “It’s a generational issue: As firms face the bubble of baby-boomer partner retirement, the problem will only get bigger.”

The firms facing the largest future liability are the Am Law 100 firms with rich guaranteed benefits paid out of current income. We independently obtained information about the plans currently or recently active at 15 of the top 50 Am Law 100 firms [see "Retiring in Style"]. All but two—Sullivan & Cromwell and Weil, Gotshal & Manges—offered unfunded pension plans. We shared our information with each firm and offered them the chance to update it; only five chose to do so. For the rest, we corroborated the information independently to the extent possible.

Many partners we interviewed told us they had little knowledge or understanding of their benefit plans or their firms’ financial liabilities. But it’s not surprising that some firms aren’t being open with their partnership: Unfunded plans, in particular, tend to divide partnerships along generational lines. “Younger partners are saying, ‘I’m never going to see the money; I’m paying to guys who were here when I was in high school,’ ” says Bradford Hildebrandt, president of Hildebrandt Consulting LLC. “ Then you have guys who are about to retire who are saying, ‘Are you kidding me? You owe it to me.’ “

It’s a division that will only intensify with time. Simple demographics dictate that payouts to retired partners will be an increasing weight on profits for at least the next decade, and maybe two. “The 45-year-old types are enormously productive and are diverting money to satisfy 68-year-olds,” says Peter Kalis, chair of K&L Gates, a firm that phased out its unfunded plan in the late 1980s. “When those [younger partners] are attracted to go to firms without that overhang, that business model [of the firm with the pension] fails. That day may never come, but it’s important to consider.”

Historically, many firms set up unfunded plans. Many of these plans are still in place, though often current partners are no longer accruing benefits under them. “The theory was that these partners built the firm, and we owe it to them,” says Hildebrandt. There is no mechanism for funding; retired partners’ pension benefits are scooped out of the firm’s current profits—in much the way that Social Security payouts are funded by payroll contributions from current workers.

Generally, it is the lockstep or modified lockstep firms that still embrace unfunded plans. At these firms the benefit is usually calculated as a percentage of compensation, typically 20–30 percent of the average of a retiring partner’s highest-compensation years. Partners vest in the plans after 20–30 years of equity partnership, though in some cases partners can partially vest in as few as ten.

Firm leaders describe these unfunded plans as golden handcuffs. Noncompete clauses built into nearly all the unfunded plans mean that partners lose their pensions if they join another firm [see "Taking It with You"]. As a partner approaches the age of 48 or 49, with vesting just around the corner, it becomes hard to leave. “Those of us who have been seeing our net income get hit every year are looking forward to receiving [the pension],” says one senior partner.

Because benefit levels are linked to a partner’s highest-earning years, payouts have ballooned, as the Simpson example shows. In the early to mid-nineties, senior partners at the most profitable firms earned around $1 million; a 30 percent annual benefit of $300,000 might have been typical. But these days, senior partners at the most profitable Wall Street firms may take home $3–4.5 million a year, generating an entitlement of $1 million or more for life. “They’re making a fortune in their retirements,” says consultant Peter Zeughauser, chair of the Zeughauser Group. “There are many who are making more in retirement than they ever imagined.”

Such plans assume a level of confidence in future financial performance. “Our plan works as long as the firm continues to grow profitably,” says Thomas Reid, managing partner of Davis Polk & Wardwell, which guarantees partners 30 percent of their highest compensation years for life. “We have a handle on our demographic in terms of who is approaching retirement. We have sufficient asso­ciates moving toward partnership, and we’re confident that retiring partners can be replaced without any adverse impact on profitability. I know there are some firms that have struggled with this, but it’s not an issue for us.”

Some younger partners at the firms with unfunded plans, however, lament the drain on their current income, and many also worry that their firms’ business strategies are increasingly driven by the need to fund partner retirement. An unfunded plan “puts a huge onus on the firm,” says a partner at a firm with a generous plan who spoke on condition that he and his firm not be identified. “It forces you . . . to grow in order to pay the pension fund.”

Younger partners also express skepticism about the future viability of unfunded plans. “Everyone understands it’s a crapshoot,” one such partner wrote in an anonymous flash survey we conducted in January on this topic. “It is, in effect, deferred compensation.”

In 1997 the Internal Revenue Service began allowing firms to establish prefunded, tax-advantaged defined benefit plans. Under these plans, firms invest a portion of current income in a firm-managed portfolio each year, with the contributions and investment proceeds dedicated to funding future retirement payouts. The plans looked more like 401(k) plans—partners were assigned notional “accounts” that are credited with a set growth rate—but just like pension plans, they guarantee a benefit [see "A Pensions Primer"].

Additional IRS changes in 2000 and 2002 substantially increased the maximum individual annual benefit under these plans. (For 2012 the maximum per retiree under an IRS–approved defined benefit plan is $200,000 a year; the annual contribution limit under defined contribution plans like the Keogh or HR.10 plans is $50,000; and for 401(k) plans, $17,000.) Increasingly, a combination of IRS–qualified plans began to look like an attractive alternative to the unfunded plans, says Philip Deitch, a partner at PricewaterhouseCoopers LLP who specializes in law firm actuarial planning. Firms hoped to thereby eventually avoid having current partners fund retired partners’ benefits, though they still have to pay for accrued benefits for many years. Deitch estimates that about eight in ten Am Law 100 firms now have some form of tax-qualified defined benefit plan.

But the plans, while enormously popular, are not necessarily a panacea. “There are significant risks associated with certain types of defined benefit plans,” most notably traditional cash balance plans, says Deitch. Unlike in a 401(k), the payout to individual partners in a cash balance plan is not linked to the actual performance of the investments, but to an external interest rate, such as a Treasury index rate. If a firm’s investment portfolio underperforms that rate and falls short of the amount needed to fund the guaranteed level of benefits, partners have to make up the difference, either out of current income or in years to come. Unless firms adopt a stringent pay-as-you-go approach, “they risk creating subsidies between . . . generations of partners,” says Deitch.

Firms learned this, to their dismay, in 2008 and 2009, when the balances in many firm-run retirement portfolios fell by 20 percent or more, Deitch says. The problem was especially acute at firms that had established non-tax-advantaged plans with much higher guaranteed benefits than the tax-advantaged plans. According to a senior partner at a New York law firm, some firms had invested retirement money in hedge funds, and these funds plummeted in 2008–09, just as overall firm profits slid. “Everyone got excited about hedge funds and their great returns” in the 1990s, when their returns beat the equity markets, this partner says. “Well, that didn’t work out so well for us.”

In the first quarter of 2011, as part of its annual Law Watch survey, Citi Private Bank asked its clients, a healthy proportion of Am Law 200 firms, about their obligations to retired partners. Roughly 40 percent of firms, including those with unfunded and underfunded pension liabilities, projected a shortfall between future obligations to retired partners and funds firms had allocated to pay for them; those indicating some shortfall included 21 of the Am Law 50 firms that report to the bank, and 23 of the Am Law 51–100 firms. Among firms that projected a shortfall, Citi determined that the gap between future funds available and projected aggregate payouts to retirees ranged widely—from less than $1 million for some firms to more than $100 million for others; Citi did not disclose the average amount of exposure.

Firms with both unfunded pension plans and the newer defined benefit plans generally have moved to limit their annual liability by instituting caps on the percentage of firm income that can be used to fund retirement benefits in any single year. In researching this story we found that caps usually ranged from 3 to 5 percent. But for some firms with The Am Law 100′s highest profits per partner, caps ranged between 10 and 15 percent, and at one firm, Cahill Gordon & Reindel, the cap was 20 percent as recently as 2007. (The firm declined to confirm or update that information.)

In recent years many firms reduced their caps, we learned. But the caps may lead to a false sense of security that the firm has its financial obligations under control; in reality, most plans bar firms from giving retired partners a pension haircut even if the cap is surpassed. The cap simply allows a firm to reduce pension payouts temporarily; it then has to pay out the shortfall as soon as it can meet its obligations without breaching the annual cap. Meanwhile, overall future liability remains unaffected.

Though our reporting did not uncover any firm that had breached its cap, several law firm financial consultants and managing partners say that day is soon approaching for many firms, given the demographic realities: Through the nineties and well into the last decade, the size of equity partnerships at Am Law 100 firms expanded rapidly. But firms began applying the brakes in recent years [see "A Growing Obligation"]. Firms will also be paying retired partners longer: Average life expectancy is expected to rise from 78 today to a projected 80 by 2020, according to U.S. Census Bureau data. Never will so many retired partners be supported by so relatively few active ones.

The future challenges and future liabilities for firms that have shifted to investment-funded defined benefit plans (including both tax-advantaged and non-tax-advantaged plans) are distinct from the firms with unfunded plans. Since the 2008 recession, these firms have been wrestling with how best to invest funds, and how much to ante up now, to ensure that they can cover future guaranteed benefits.

For firms with tax-advantaged plans, relief may be on the way. In late 2010 the IRS approved a new kind of defined benefit plan, called a market-rate cash balance plan, that reduces investment risk. These plans for the first time link benefit levels to actual investment performance on a chosen portfolio, much as 401(k) plans do. “We’ve seen many of the largest firms up and down The Am Law 100 looking at these plans,” Deitch says. He says many firms that want to implement the new market-rate plans are considering whether to terminate their old cash balance plans. The IRS allows partners to roll the accrued assets into IRAs.

Banks like Citi, meanwhile, are advising firms that want to terminate their underfunded plans about new ways to fund the shortfall. According to Michael McKenney, who heads credit origination at Citi Private Bank’s Law Firm Group, firms are exploring financing the difference between projected funds and payouts through term loans or life insurance. (In the latter scenario, firms buy insurance on all their partners; the firm’s pension fund is the beneficiary.) Because interest rates are low, McKenney says, depending on a firm’s demographics and future pension obligations, it could make sense to borrow money now to fill a projected funding gap, rather than waiting until later, when borrowing costs may be higher.

It’s much harder to substantially reduce future liability with the unfunded plans. Eliminating or substantially scaling back the benefit formulas is tough. With partners closest to retirement unwilling to make sacrifices, and new partners lacking clout, it is often the partners in their late forties and early fifties that have to take the initiative—and absorb the brunt of any reductions. Many who have gone through it say that the process is an emotional minefield. “We fought about this,” recalls the head of one Am Law 100 firm, discussing efforts to reduce his firm’s future benefit guarantees. “The older partners should have exhibited leadership. They didn’t.”

One recently retired partner from Foley & Lardner says that there was widespread tension over the management committee’s decision in 2009 to freeze the firm’s traditional pension plan to current participants and at current prorated vesting levels; the old plan guaranteed partners with 30 years of service an annual benefit of a quarter of the average of their three highest-earning years. Says this partner: “I worked under a partnership agreement that promised me something. I don’t feel that I’ve gotten a gift. But I feel for the people who will be missing out on that benefit.” (Foley declined to comment on its pension plan or changes to the plan.)

To “avoid pulling the rug out from anyone,” as one managing partner put it, some firms are gradually reducing their benefits levels. Beginning in 2008, for example, Paul, Weiss, Rifkind, Wharton & Garrison reduced its benefit percentage from 25 percent of the average of a partner’s top-compensation years to 20 percent. The firm will continue to reduce the percentage by a half-percentage each year until the obligation drops to 15 percent. The firm has also gradually lowered its cap, from 15 to 8.5 percent of total firm income; by 2014, the cap will be 7.5 percent. (The changes apply only to active partners, not retirees.)

To get rid of the unfunded plans entirely takes a strong commitment from firm leadership and years to accomplish. Charles Smith, a senior ERISA partner at K&L Gates who spearheaded his firm’s overhaul in the mid-eighties and manages current benefit plans, says he had to meet with and persuade each of the roughly 100 partners then at the firm to agree to phase out the unfunded plan and change over to 401(k) retirement funding. At the time, retiring partners could look forward to receiving 40 percent of their last three years of compensation for life. “I knew it was a time bomb if the firm continued to do it,” Smith says.

Even so, the firm is still whittling down its unfunded liability more than 25 years later; there are two or three partners still receiving benefits under the old plan.

K&L Gates has also recently sought opportunities to increase retirement benefits. In 2009 the firm was an early adopter of the new market rate plans (it set up the program under draft rules that became fully effective this year). In exchange for security down the road, the firm promises a very low growth rate, investing in short-term Treasuries and similar instruments. “This is your sleep-at-night money,” Smith says. “If I can get, in today’s market, 30 basis points, I’m doing just fine.”

Such plans still expose firms to limited liability. Under IRS rules, when a retired partner receives a distribution from the plan, he or she must receive an amount at least equal to the contributions he or she has made to the plan. In the unlikely event of a shortfall, the firm must cover it, but in turn, the firm charges that payout against the partnership account of the partner receiving the distribution.

K&L Gates got the job done at a time when its partnership was young, small, and spread between just two offices. Most firms hoping to change their plans now aren’t so lucky. But doing nothing has become increasingly risky. At a time when it is by no means certain that even the best-positioned firms can continue to grow their way out of a pension problem, it is worth considering whether the sums being paid to partners who were lucky enough to retire at the tail end of an economic boom can still be justified.

Let the conversation begin.