October 23, 2012

Promises to Keep: Solving the Dilemma of Unfunded Deferred Compensation Plans

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Rising to the Challenge



Business Feature

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.

How Past Promises Play Out Today

Let's begin by illustrating the nature of the situation with three scenarios.

  1. In 1977, Geoffrey Great and Barry Big decided to bring a third partner into their flourishing practice. Publicity from a string of high-profile courtroom triumphs was attracting what seemed to be an endless series of new cases. They approached Fiona Firm, a big firm associate who readily agreed to the invitation, but who asked for a plan to replace the nonqualified deferred compensation arrangement she would be leaving behind. Convinced that their caseload, as well as the number of associates they could bring on board, would only grow over time, they all agreed to modify Great and Big's partnership agreement to provide that any partner could elect to retire at or after age 65, and would receive a draw for life equal to the average of the individual's last three year's partnership share.
  2. In 1987, Sue Barrister was a young partner with Garner & Wages, a firm specializing in bankruptcy law. At the time, she was considering several partnership offers from larger firms. Seeking to retain her services, Garner & Wages offered Sue an unfunded deferred compensation plan that provided that if she were to stay with them for another 20 years, then upon her retirement, the firm would continue paying her an amount equal to her annual salary at retirement for five more years. If she were to leave the firm before that time, she would receive nothing. At the time the arrangement was created, Sue's annual base salary was $40,000.
  3. In 1997, the law firm Mahzel & Tov was enjoying good times. The firm had 27 partners, all earning strong six-figure incomes. That year, one of the partners, Carl Mahzel, decided that he had more money than he knew what to do with, and since he could not contribute any more to his qualified retirement plans, he wanted to find a way to defer any future bonuses until his projected retirement in 10 years. The firm decided to offer him a deferred compensation plan in which he would forgo all annual bonuses in return for the firm paying him, upon retirement, $150,000 each year for life. The agreement was unfunded, which seemed of little concern at the time because of the firm's seemingly endless cash flow.

Fast-forward to 2007 and...

  • Great Big Firm has grown into a multinational firm with 87 partners and 242 associates practicing in offices located in Houston, Seattle, London, Paris and Istanbul. The three name partners are now between the ages of 57 and 63. They still run the firm, although younger colleagues also serve on the management committee. The firm's deferred compensation plan, which is beginning to present serious recruiting and retention problems, is on the agenda for the next management committee meeting.
  • Sue Barrister is retiring at the end of this year and is expecting that the firm will pay her the deferred compensation as promised. Her annual base salary is currently $200,000. The firm of Garner & Wages is no longer quite as prosperous as it once was, and with Sue's departure, many of the firm's key clients may go elsewhere. Many of the partners see the deferred compensation owed to Sue as an anchor that will sink the firm, and they're considering leaving.
  • Carl Mahzel has been retired for more than a year. None of the firm's five remaining partners will receive a bonus this year, and base salaries have actually decreased since the firm's heydays in the mid-1990s. The firm lost many of its big clients when partner Marc Tov, its principal rainmaker, left in 2000. The firm has only recently stabilized and is having a difficult time attracting new partners, in large part because of the deferred compensation commitment to Carl.

What Went Wrong?

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.

How Deferred Compensation Works

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.

Options for Law Firms

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.

Terminating the Deferred Compensation Plan

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:

  • Does the existing plan authorize termination of the participant's rights in the plan by mutual consent? If not, the plan cannot be amended after December 31, 2005, to allow for termination of either the plan or the rights of a plan participant.
  • Termination of a deferred compensation plan will cause the participant to include in current income all distributions (or required distributions) as a result of the termination. This could be disastrous if, for example, a deferred compensation agreement contains a provision requiring the deferred compensation to be paid upon plan termination.
  • If the participant in an unfunded deferred compensation plan has not yet vested in any benefit (as in the example of Sue Barrister, from our earlier scenario), then termination of the plan by mutual consent should not trigger a distribution event.

Modifying the Deferred Compensation Plan

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.

Paying the Benefits

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.

  1. Cash flow. The "pay as you go" method is what got many firms into trouble in the first place—but it may be the only way to fund payment obligations when it comes to participants who are close to, or already in, payout mode.
  2. Deferred annuities. They are not the best choice for a couple of reasons. First, if the annuity is owned by the law firm (see "rabbi trust" below) it will lose its tax-deferred status, usually a pretty big reason for buying a deferred annuity in the first place. Second, if payments are due now or in the immediate future, getting money out of a deferred annuity on a short-term basis may be difficult and also result in surrender charges.
  3. Immediate annuities. A single premium immediate annuity, often referred to as an SPIA, is an excellent choice if the firm has the ability to fully fund its deferred compensation obligations upon the triggering event (such as retirement). By buying an SPIA, the firm shifts investment risk (and mortality risk as well, if the obligation is for life) to a third-party.
  4. Cash value life insurance. This option works best for a younger partner in a deferred compensation plan, usually 10 years or more away from retirement, because it gives greater opportunity for the cash value in a policy to accumulate. In a typical situation, the firm would be the owner and beneficiary of the policy. The participating partner would be the insured. The plan would offer a survivor benefit (taxable to the plan beneficiary) if the partner died while employed (paid for with the life insurance death benefits), and a post-retirement deferred compensation benefit (which the firm could access policy cash values to help pay for). Life insurance cash values can grow tax-deferred, unlike deferred annuities that lose their tax-deferred status when owned by a non-natural entity such as a law firm.
  5. Rabbi trusts. A rabbi trust is not an investment. It is a trust to which the firm contributes money for future payments to a participant. Once the money is in the trust, the firm cannot access it for any other purpose. The money, though, is still subject to attachment by the firm's creditors, creating a "risk of forfeiture" that allows the plan to qualify as being "unfunded." There are no investment benefits to holding assets in a rabbi trust, since it is treated as a grantor trust and all tax attributes of the trust flow back through to the law firm.

What's the Solution for Your Firm?

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.