To say that we are in trying economic times may be a bit of an understatement if you are unemployed, underemployed or employed at a reduced compensation rate. That is, unfortunately, the situation many lawyers are facing these days, as firms continue to make serial adjustments to their personnel ranks, with layoffs, furloughs, reduced hours, and wage freezes and reductions all part of the arsenal.
Law firms have struggled to find equilibrium between the work available and the staffing required to do it, as well as between the price clients will pay for that work and the cost to the firm to service it. In adjusting to the new economic reality, you can see that there’s a tremendous amount of humanity in the profession—you can sense it in the concern that leadership has over the cost cuts they must make and how that affects their people. But at the same time, there is also less patience with -underperforming lawyers. Firm cultures are under great stress, and the cultural belief that “we are all in this together” works within limits. The current economic situation has stretched, and in many cases exceeded, those limits.
Much of this has to do with the economic model of private law practice in the United States. Generally, the cost structure of a typical law firm is 78 percent labor, 8 percent facility and technology, and 14 percent “other.” The facility and technology costs most often involve long-term leases and contracts that will not be easily broken. The “other” category has potential savings, but there are some practical realities because this category includes your basic operating costs—a goodly portion of which are not going away. You can conserve on some, maybe defer some and eliminate a few, but that’s about it.
That leaves labor and its associated costs. Law firms have a variety of options for reducing those, depending on the depth and likely duration of the shortfall in work, as well as the firm’s need for immediate expense relief. Drastic work-staffing imbalances will direct a firm to certain options, whereas an imbalance at a lesser, more manageable level will open up different remedial measures for consideration.
So then, what are the options when it comes to altering lawyer compensation to reduce costs? It’s a critical question, given that law firms are such labor-intensive businesses. That is where the money goes, and that is where the savings options are. And with their limited access to capital, the length of time that firms have to correct labor-cost imbalances is preciously short. Here is what smart law firms are doing with respect to compensation as today’s economic events rain down on them.
Partner Compensation: Addressing Key Market Factors
First, smart firms are putting into perspective the risks they face with regard to key talent. If key business generators perceive their compensation to be inadequate, or their firm to be at risk of floundering, they may take their clients and leave. Highly talented, technically skilled lawyers who do not feel secure in their current firms are often quite open to recruiter inquiries to move to more financially stable firms. And, be assured, there are enough firms in good financial shape with adequate capital to take this opportunity to shop strategically for talent. Sadly, the drain on talent usually starts at the top of the chain and works its way down. If management allows a drain like that to continue for even a short while, the lawyers remaining in the firm may not constitute a sustainable enterprise.
Second, there is a stricter enforcement of economic contribution expectations. The recession has eviscerated entire practice groups, remember. While a firm might absorb the loss of a few clients, it is hard-pressed to do so for many. Accordingly, the window to right or retool a practice has become much shorter—months, maybe a quarter or two, but not a whole year. Consequently, firms are considering more individualized compensation adjustments if a first round of across-the-board reductions is insufficient.
Third, partner compensation systems have commonly considered past performance (average and trends) equally with current year performance in setting compensation. That balance, however, is now shifting so that recent performance receives greater weight.
Fourth, forward-thinking firm leaders have a heightened concern about what message their partner compensation decisions convey, both to the people inside the firm and to the outside pool of future potential recruits. There is keen pressure to make the very best decisions, to reinforce leadership messages by rewarding specific qualitative behaviors, and to provide pay proportionate to performance without abandoning firm values.
The challenge of getting this right in the midst of so much turmoil is daunting. Therefore, law firms should try to reframe the process using these key questions:
What is the firm paying for?
What messages do the firm’s decisions send?
Are the decisions consistent?
Do they reflect what the wider market would pay?
Current economic circumstances require a sharper focus, a more disciplined approach, and a more internally consistent and externally competitive set of decisions. To do this analysis and achieve these ends, knowledgeable firms use correlation studies and market risk assessments, among other things, to determine how their compensation decisions can be improved.
Associate Compensation: Rolling Back Salaries and Lockstep Programs
Associate compensation decisions involve other types of challenges, of course. There is currently a great deal of talk about retooling associate compensation, with most of it centered in two areas. The first is an absolute rollback of starting compensation that will ultimately affect every class year. The second is reform or elimination of the lockstep programs that are entrenched in many firms.
The first, salary rollbacks, is a reality-check arising from client pressures. Clients are increasingly hesitant, if not downright unwilling, to accept first- and second-year associates on their matters. In many firms, these associates’ billing rates—necessitated by supersized compensation packages and equally supersized overhead, the combination of which can equal $500,000 in large firms—have far exceeded the value these newly minted lawyers can offer. Currently, reductions seem to range from 10 to 20 percent in base salary across the board.
Now that enough market leaders have reduced associate compensation, it will be much easier for the balance of the profession to do likewise. The effect of this? It will lower costs and ease cash flow immediately. It will also reduce the gap between market leaders and the pay levels of the rest of the pack, as well as between large firms and small firms. And since the associate pay reductions appear to be predominantly among market leaders and large law firms, the trend could, interestingly, allow a very few firms to hold the line and finally achieve in the recession what they could not accomplish with relentless pay hikes: a separation in starting pay that is not immediately matched by the market.
The second area, lockstep associate compensation, has been talked about for years. A few firms have taken on the issue with reforms of varying degrees, including abandoning the concept altogether. However, it’s unclear whether those reforms will really yield substantive change in how associates are being compensated. Remember, there are two reasons why lockstep has lasted so long.
First, it is easy for the firm to administer, particularly when it knows that a sizable percentage of its young lawyers will transfer out within a few years. For the single-tier firms, this turnover of associates is a necessary event, since only a few will survive the tournament to the top in the end anyway.
Second, for all of its purported shortcomings, the lockstep system has resulted in remarkably merit-based compensation decisions.
How can the latter point be said with certainty? Well, there is a reliable means to determine how important merit is in associate compensation decisions. The test is a statistic known as R-squared, which tells how much of the variation in compensation can be explained by a particular variable. In the case of associates, the variable that is examined is: performance measured by value of the associate’s recorded time. Based on our large databases of associate time and productivity, the strength of the relationship (R-squared) between the value of associates’ time and compensation is remarkable at 0.92 where 1.0 is the maximum value. Essentially only 8 percent of the variability in associate compensation is explained by all factors other than productivity.
Can you get more merit-driven than this? Not if you want any ability to consider other aspects of the associates’ contributions. In professional services, where the model is selling the value of your experience and expertise, the foundation of any compensation program has to measure time value. Smart firms will be keeping this in mind as they continue to investigate how to retool compensation.
After the Market Shakes Out?
For now, law firms are in triage mode. Good partner compensation decisions that limit the risk of losing key people while also recognizing short-term performance are paramount. Associate compensation is, of necessity, for many being reduced to reflect current economics. Looking past now to the longer term, however, law firms may very well need to make larger changes to systems and processes.
As the recession fades, we will gain a better sense of which old market forces will survive, and in what manner, and which will give way to enable more thoughtful, programmatic compensation programs.
James D. Cotterman is a principal of Altman Weil, Inc., a legal management consultancy headquartered in suburban Philadelphia. He advises clients on compensation, capital structure and other economic issues.