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By Ann L. MacNaughton and Barton J. Bradshaw
When your partners are ready to retire, will your firm be ready to fund the lifetime stream of retirement income that was promised? Scenarios and possible solutions for law firms to consider.
Law firms today are markedly different in many ways from firms in 1977, 1987 or even 1997. The Internet, multijurisdictional practice and an expanding array of technology tools are among the significant changes. But also, though perhaps less-widely cited, there's the fact that today's law firm partners earn more money and live longer, and many seem to want to retire earlier than ever before. As a consequence, it has become a far different proposition to promise—and fund—a lifetime stream of retirement income than the makers of such promises envisioned when many of today's firms were forming and expanding in the 1970s through 1990s. This was true even before the American Jobs Creation Act of 2004 added new Section 409A to the Internal Revenue Code.
Now, an extra layer of legal requirements adds additional constraints and complexities to firms seeking solutions. Financial products and mechanisms that address retirement income needs of law firm members who may expect to live well into their 90s are beyond the scope of this article. The following, instead, describes solutions for law firms struggling with unfunded retirement liabilities that are creating revenue, retention, recruiting and long-term viability challenges.
Let's begin by illustrating the nature of the situation with three scenarios.
The troublesome situations faced by the fictitious firms in the preceding scenarios are not unusual. In fact, many law firm partnerships are burdened—and their ongoing viability threatened—by past promises to provide retired partners with substantial incomes after retirement, sometimes for life. These promises were made back in the "old days" when firms were smaller, partner incomes were lower, and "for life" didn't contemplate current actuarial projections of retiree longevity.
Typically the promises were made without funding, causing the income streams of earning partners to become increasingly burdened by annuity-like cash flow obligations to retired partners. As a result, established partners today may choose to leave the firm—with their clients—simply to avoid these payment obligations and their revenue impacts. New partners may become difficult to attract, too, knowing that their own income might be saddled for years with payments to retired partners whom they never even knew.
Under the weight of these obligations, a firm may have no choice but to simply fold, leaving the retired partners who are owed compensation high and dry in turn.
Most unfunded deferred compensation plans used by law firms today are now governed by Internal Revenue Code Section 409A, enacted as part of the American Jobs Creation Act of 2004.
Under Section 409A, a plan will be considered to provide "deferred compensation" only if it provides plan participants with a legal right to compensation that has not been received or included in income, and only if such compensation is payable to the plan participants in a later year. There is no legal right to compensation if the firm can reduce or eliminate the amount of those future payments in its sole discretion after the services have been performed.
To ensure that compensation is not includable in an employee's gross income until actually received, a deferred compensation plan must consist merely of the firm's unfunded, unsecured promise to pay a specified benefit at a specified future date. Participants in these plans are general, unsecured creditors of the employer with respect to their deferred compensation benefits.
How a law firm deals with the problems of guarantees associated with unfunded deferred compensation plans will vary according to individual circumstances. Terminating the agreement is one option, although getting the approval of a retired or retiring partner to whom the obligation is owed may be tricky. Another approach is to modify the existing agreement so as to reduce the payment obligations to a level that the firm and also its retired, and retiring, partners all will agree to accept. Another option, of course, is simply to pay what is owed and hope that the well doesn't run dry while the camels are still drinking. Let's look at the pros and cons of each option.
The longer the plan has been in effect and the more benefits that have been promised, the harder plan termination may be to accomplish. Much may depend on how much the retired or retiring partner is or will be owed under the plan, the manner in which the firm has managed its succession planning, and the strength of the partner's personal relationship with the remaining members of the firm. Even if the former partner does agree to terminate the plan in its entirety, the following issues will still need to be addressed:
Modification may be a more practical solution than complete termination. A retired or retiring partner may very well choose to accept a lesser or more extended benefit payment, knowing that the alternative might be the eventual collapse of the firm (and, of course, its ability to make any payments). In fact, working to cap or reduce unfunded deferred compensation benefits (such as to a percentage of either gross revenues or net income) may be a good idea for all partner participants, not just those at or close to retirement.
According to the Altman Weil Retirement and Withdrawal Survey for Private Law Firms, 2005 Edition, "many unfunded plans are being modified with payment caps, reduced benefit formulas, longer vesting requirements and other strategies to limit or reduce the future economic burden on law firms." The report goes on to say that "over two-thirds of firms report amending their deferred compensation plan since 1990, most commonly by lowering a pre-existing payment cap, lengthening the payout term or adding a cap for the first time."
As explained earlier, amending an existing plan requires not only the consent of participants, but also compliance with Internal Revenue Code Section 409A. The good news is that it is still possible to amend most existing deferred compensation plans without running afoul of the new rules, as long as "material modifications" are not made. A material modification occurs if a benefit or right existing as of October 3, 2004, is enhanced or a new benefit or right is added. Amending a plan to stop all future deferrals (freezing it) is not a material modification. Amending a plan to reduce the benefits offered to a participant should not necessarily be considered a material modification, although, of course, this will depend on the specific facts of the situation.
In addition, under the rules, the time and form of distributions must be specified either in the plan document or at the time of the initial deferral.
The participant has agreed to a reduced benefit, or perhaps the firm has simply given up and resigned itself to having to pay out what it originally promised to a retired or retiring partner. The question then becomes how best to fund or pay for this obligation on such short notice. If the firm decides to buy a financial product to help with this obligation, ownership, beneficiary and payee designations must be carefully considered to avoid creating taxable income to the participant prior to the desired time of distribution.
Here are related issues to consider.
Ultimately, the answer for law firms saddled with financial promises that may be difficult to keep will depend on the firm's specific situation and resources, as well as the age and circumstances of the affected partners.
Obviously, legal constraints and complexities must be carefully analyzed, with the assistance of competent legal counsel. Depending on the particularities of any given situation, targeted use of immediate annuities or cash value life insurance are likely among the best ways to address revenue, retention and recruiting problems arising from those old promises.