Law firms are grappling with gradual increases
in obligations to retired partners at a time when many can ill afford it. But as retirements have surged in the past few years, many firms have taken remedial actions to limit their exposure.
In general, firms carry three kinds of financial obligations to retired partners: the return of capital; topping-up of defined benefit plans, where a partner contributes a set amount during his or her career, but the firm guarantees a specified retirement payout; and, for a score or so of firms, funding traditional, unfunded pension payouts. In each, firms are finding multiple ways to mitigate potential damage.
There’s been a gradual uptick in firms’ payouts of retirement obligations, according to Gretta Rusanow, head of the advisory services at Citi Private Bank’s Law Firm Group. The uptick is greatest among the largest firms, she says.
In 2010, firms in their survey, which includes most of The Am Law 200, paid retired partners $9.7 million on average, or 1.2 percent of revenue for that year; the Citi data includes obligations to unfunded or underfunded retirement programs. That number has crept up to 1.5 percent in 2014, or an average of $14.5 million per firm. “I don’t want to set off a fire alarm, but it’s growing,” Rusanow says.
At a time when profitability growth at Am Law 100 firms averaged 4 percent last year—and many firms experienced even slower growth—1.5 percent represents a substantial chunk of annual profit increases. When many firms instituted the pension plans, “they really never anticipated that they might have retirement obligations that would be multidecade obligations. You now have multiple six-figure incomes going out” at many firms, notes Citi’s Rusanow.
For the 61 percent of Am Law 200 firms offering plans that guarantee partners a defined retirement benefit, the risk is that the market will go south, and firms will have to contribute multiple millions of dollars to top up the plans
to meet guaranteed payout levels. To avoid this, many have begun slowly phasing them out and starting new “defined contribution” plans where the partner, rather than the firm, is exposed to market risk.
In 2013, for example, Haynes and Boone froze its defined benefit plan and invited partners to begin contributing to a market-rate cash balance plan, which defines the promised benefit in terms of a partner’s account balance—eliminating the firm’s exposure to investment declines. “I think for people in the upper echelons of firms, they don’t need that kind of defined benefit plan anymore,” says managing partner Timothy Powers. The current plans, combined, provide retiring partners with $250,000-$400,000 a year, he says:
Partners “need to save their own money if they want more.”
Weil, Gotshal & Manges likewise began scaling back its defined benefit plan four years ago while phasing in a mandatory defined contribution plan. “We still will have both,” says managing partner Barry Wolf. “There will be no decline in benefits, but it’s a different risk sharing.”
Capital is also on some firms’ minds. Generally, capital is pegged to compensation levels, so large firms are being forced to fork over much more capital to the relatively high-paid retiring partners than they’re collecting from the cadre of new, relatively junior partners. The imbalance can cost firms millions of dollars a year, depending on the number of retirees and the percentage of equity that must be paid back. “Firms have a lot of boomers approaching retirement, and they have a lot of capital that’s going to go out faster than they’re going to get capital coming in,” notes Altman Weil Inc. principal James Cotterman, an expert in compensation issues. “The new partners are going to be buying in at lower numbers. Firms might need to adjust their capital retention to be able to manage their way through the changing of the generational guard.”
Some mostly younger firms that maintain “accrual basis” capital systems—where each partner accrues a percentage interest in future accounts receivable for matters that partner has originated during his or her entire career—are facing much higher payouts. At IP firm Knobbe, Martens, Olson & Bear, for example, the total can represent several million dollars per partner, says one partner. The firm, which has a mandatory 65 retirement age, pays out that accrued capital account over the first few years of retirement. The firm says it expects five to 10 new retirements in the next five years.
The Trouble With Traditional Pensions
The most serious troubles, however, challenge firms that maintain traditional pension benefits, which are paid out of annual profits—much like Social Security is funded with annual tax receipts. Some 23 percent of partners say their firm has such a plan, according to preliminary results of Major, Lindsey & Africa’s 2016 Partner Compensation Survey, which is set to be published later this month. Firms that maintain the plans include many New York elite firms, almost all with lockstep or modified lockstep compensation systems. They also include several Texas firms and a few others.
The rapid, two-decade-long expansion of firms beginning in the late 1970s, followed by a slowing of that growth since 2009, means that fewer working partners are carrying the burden of supporting more retirees. Also, since partners now are living significantly longer than previous generations, the total payout liability is greater for the subset of firms that guarantee a lifetime benefit. According to the National Center for Health Statistics, the average American this year is expected to live until 79, up from 73 in 1980, and life expectancy is expected to hit 81 by 2027, when the youngest boomers retire.
“The demographic has changed dramatically,” notes Bud Schiff, managing director at Alvarez & Marsal’s executive compensation and benefits division. Firms “never thought that retired partners were going to live another 30 years. The ratio of active to retired partners is no longer 10-plus to one, it sometimes is two to one.”
Another factor is increasing that burden: increases in partner compensation—and thus the amount of a pension linked to that compensation—have far outstripped inflation. In the early to mid-90s, for example, a retiring partner at a highly profitable firm might have earned as much as $1 million, generating a $250,000 annual benefit for a plan offering 25 percent of previous compensation. These days, however, senior partners at elite firms may earn as much as $4 million to $5 million a year, generating a lifetime annual entitlement of
$1 million or more for some pension plans.
To soften the hit on profits, at least half the firms with such pension plans have made changes in recent years to freeze participation in the programs or to reduce payouts in other ways.
Some, for example, have raised the age at which a partner can retire with full benefits. Others have lowered the cap on how much can be paid out of annual earnings to retirees. Still others are reducing the payout formula to more sustainable levels. Because changes are phased in over many years, however, it takes several years for any change in a plan to make a significant dent in the liability.
Milbank is an example. Its change, which it initiated in 2012, will take 15 years to take full effect. Its partners, until recently eligible to receive 25 percent of the average of their highest compensated years for life, will eventually be eligible for 18 percent. Total annual exposure for the firm will be capped at 10 percent of earnings, down from 15 percent. Meanwhile, partners will need 25 years to vest, up from 20. Similarly, Paul, Weiss, Rifkind, Wharton & Garrison in 2010 began reducing its pension benefits—20 percent of the average of five of the highest compensation years of a partner’s career—over a 15-year span to 15 percent of past highest compensation, down from 20 percent. The annual payout cap will fall to 7.5 percent, from 10 percent. And Cravath, Swaine & Moore has dropped its cap from 15 to 10 percent, and lengthened the path to vesting, from 20 years as partner to 30, including associate years.
Other firms with heavy pension burdens include Davis Polk & Wardwell, Simpson Thacher & Bartlett and Debevoise & Plimpton; all declined to say whether their policies have changed since 2012, the last time that The American Lawyer collected detailed pension plan information. At Davis Polk, for example, partners on average retire at age 61, receiving 30 percent of the average compensation their three highest-paid years for the rest of their life—for some long-lived partners, as many as 30-35 years. As of 2012 (the most recent year for which information is available), pension payouts were capped at 15 percent of profits. Fifteen percent of last year’s profits represented $76.5 million last year, or some $500,000 per partner; the firm declined to say whether it has ever reached the capped amount.
To reduce the burden, some firms have frozen the plans. But because of the long life of the payouts, it can take more than a decade to see significant savings. To replace them, firms frequently create new retirement investment vehicles, in which partners pay in to their own retirement accounts, thus gradually shifting more financial risk to partners themselves. Cooley, for example, froze its unfunded plan in 2010, with only partners 55 and over (now 61 and over) eligible to collect full benefits, partial benefits for younger partners, and no new pensions for new partners. Fried, Frank, Harris, Shriver & Jacobson similarly closed its plan to new partners in 2014 and now has an 8 percent cap.
To go back to package hub page, click here.