UNFUNDED RETIREMENT OBLIGATIONS: A TRAP FOR THE UNWARY Michael T. Lucey INTRODUCTION

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1 UNFUNDED RETIREMENT OBLIGATIONS: A TRAP FOR THE UNWARY Michael T. Lucey INTRODUCTION Every law firm, like any business, must address the retirement of its senior members. This implicates equally important firm concerns such as transition of business and management, firm economic health and employee morale. This article addresses the challenges law firms face if their retirement obligations are unfunded. Partner retirement affects all members of a law firm. Partners who are contemplating retirement, and who have built the law firm, seek recognition, including financial recognition, of their contributions over the years, and of the risks they took to build the firm. They also seek certainty in their economic future. Conversely, newer partners often express the concern that, as partners retire, an ever increasing share of firm revenue may be allocated towards compensating retiring or retired partners. Newer partners too, seek economic certainty, but this concern is often about whether the firm will continue to be economically viable as senior partners depart. The partnership has an interest in insuring that clients and business are transitioned in an efficient and smooth manner. From the firm s perspective, a partnership retirement policy must incentivize both the retiring and remaining partners to transition business in such a way that the partnership is positively affected. Most firms address the retirement of firm partners in their partnership agreement. The type and amount of benefits to a retiring partner vary greatly, but until recently, few partnership agreements contained a funding mechanism for this obligation. Surprisingly, many firms do not address funding the retirement obligation until a major rainmaker announces his or her retirement. By failing to address the funding question earlier, firms can put their economic health and stability at risk. LAW FIRM RETIREMENT PLANS GENERALLY Most retirement vehicles can be broadly categorized as either qualified or nonqualified. A qualified retirement plan is a plan that is qualified and regulated by the Internal Revenue Service. Generally, qualified plans provide for immediate tax deduction for contributions, and tax deferral for monies within the plan. Monies in the plan exist outside of the employer or the partner, and as such are protected from creditors. Most law firms currently have a qualified retirement plan of some type. Non-qualified retirement plans, are plans that generally do not qualify for any type of special tax treatment, but they have far fewer restrictions than qualified plans. They are unsecured and normally subject to taxation. They often remain unfunded to avoid taxation in the current tax year. 1

2 UNFUNDED NON-QUALIFIED PARTNERSHIP RETIREMENT PLANS Unfunded non-qualified retirement plans, in short, pay out future profits to retiring or retired partners who generally do not contribute to those future profits. Unfunded retirement obligations generally come in two basic forms: One in which the retiring partner retains a percentage interest in the distributable income of the firm. Alternatively, the retiring partner is paid pursuant to a formula set out in the partnership agreement. These plans typically have provisions affecting the retirement age, vesting, etc. Firms with unfunded retirement obligations need to consider whether they will be in a financial position to pay out future profits to retiring partners. If not, firms need to consider how to reduce or completely eliminate this unfunded obligation. Over the years, law firms have attempted to change or eliminate these plans with mixed success. Some of the factors that firms ought to consider are the following: 1. How soon will partners be retiring? 2. How many partners will retire over the next 5, 10 or 15 years? 3. What is the total dollar amount of the unfunded obligation per year on a worse case scenario, and how will that compare to the likely net distributable income of the firm in that year? 4. Can the unfunded obligation of the partnership agreement be amended, changed or altered against the wishes of those who are currently receiving benefits? 5. Is there is a vesting provision in the partnership agreement which creates a vested right in partners who have yet to retire? 6. How does the unfunded retirement obligation align with the qualified plans currently existing in the law firm? (Keogh, 401K, etc.) Solution One: Fund The Obligation One solution to the unfunded retirement obligation conundrum is simply to fund the obligations. However, given that most partners often do not know when they plan to retire, projecting out the future benefit stream is difficult at best. Attempts made during the 1980s to fund these obligations through life insurance vehicles were generally not successful. The most significant roadblock to current funding of future retirement obligations is the tax problem. Monies set aside to fund future non qualified retirement obligations is generally taxable income to the law firm (and hence the partners) in the year in which the income was earned. Thus, partners must typically pay tax on that undistributed income. The problem with such a strategy is obvious. The other funding alternative is to simply fund the obligation once it becomes due. This reduces the income available for distribution to the partners and may result in the remaining partners being compensated at less than they perceive to be their actual value. The pending future obligation, and the resulting impact upon future profits may deter new or lateral associates from joining the firm if they are concerned that the future retirement obligation may be 2

3 significant. In addition, the presence of unfunded obligations may affect the firm s ability to acquire credit, bring on lateral partners, be acquired or merge. In short, funding future retirement obligations with then current income is problematic. Solution Two: End The Plan Completely Under this scenario, the partnership, by the appropriate vote as set forth in the partnership agreement, simply votes to end the plan immediately. This has been accomplished most successfully in those law firms which had no or few retired partners, and few partners approaching the retirement age. In firms where there already are retired partners or partners on the verge of retirement, this option is often politically difficult. As firms consider this option, firms need to consider whether an obligation exists to continue payment to those partners who have already retired, and whether those who are at or beyond the retirement age, but still working, have a vested right in the benefits under those plans. Firms also need to consider carefully if there is another method by which the firm can reward founding or institutional partners for their many years of service. One method to soften the blow is to end the unfunded retirement obligation slowly over time. This typically involves a commitment to pay existing retired partners while reducing either by time period of payment or by amount paid, the potential payout to those closest to the retirement age. Typically, those farther away from retirement receive the less. Firms employing this option typically select a point in time (in terms of seniority) below which partners would receive no benefits at all. While this approach is generally most acceptable to the widest array of partners, it has the affect of delaying the elimination of the unfunded retirement plan, often times for a very long period of time. It also keeps in play the discussion of whether an ongoing unfunded obligation is in the best interest of the law firm. Another option is to cash out the retiring or retired partners to compensate them for the loss of their unfunded retirement benefit. While this option has the advantage of ending the plan immediately and satisfying the needs of the retiring partners, it requires a significant capital outlay in a short period of time, which may impact the newer partners more greatly. This option is most easily accomplished when the firm anticipates a better than projected year. In such years, the firm can buy the retirement obligation at a discounted value. This provides the retiring or retired partners with some security in exchange for a lower obligation to the firm. If this is done in a year in which the firm did far better than projections, the impact on those non-retiring partners is less. Solution Three: Modify The Unfunded Retirement Plan If, for political or other reasons, a law firm decides that an unfunded retirement obligation cannot be eliminated, the firm should consider changes to those plans which minimize the impact on the partners and the firm. For example, capping the amount paid to retiring partners at a certain percentage of distributable net income adds some economic certainty for the non-retiring partners and, at the same time, allows the retiring partners to be able to rely upon a certain income stream. Alternatively, payments to retiring partners as a group can be capped at a certain 3

4 dollar amount, either in total or on an annual basis. Again, this has the advantage of adding some economic certainty to the process, and allows the firm to budget the retirement obligation. However, creating caps without consideration of firm profitability or net income creates the same funding conundrum. A firm that attempts to fund retirement obligations through debt or capital calls is only asking for trouble. Any changes, of course, must be consistent with the partnership agreement. Often, making such a change requires a modification to the partnership agreement. Finally, if a firm is intent upon maintaining an unfunded retirement plan, then it behooves the firm to increase the notice period for announcement of retirement to as long as possible. If a retiring partner must give three, five or seven years notice of an intent to retire, the partnership can better prepare economically for the retirement event. However, the partnership (and thus the individual partners) will ordinarily be taxed on the partnership income earned in that year, but set aside to fund the future retirement obligations. While it is possible to fund a retirement obligation through the purchasing of annuities, the time periods are generally too short (from notice to pay out) to make them cost efficient. In addition, while the growth in the annuity may be tax deferred, the partnership will ordinarily be taxed on the monies set aside to purchase the annuity. Retirement notice provisions often include a billable hour scale down whereby, after giving notice, the partner is allowed to reduce his or her involvement in firm matters, billable hours, etc. If the scale down results in the retiring partner becoming unprofitable during the scale down period, it can have the effect of actually prolonging the economic impact of the retirement upon the firm. In addition, most firms now avoid pegging the retirement phase down income to the retiring partner s previous income levels because it creates an incentive for the retiring partners to hoard business at a point in time when the partner should be transitioning that business. Solution Four: Eliminate Unfunded Plans, But Increase Qualified Plans To lessen the blow to retiring partners by the elimination of unfunded retirement payments, firms often institute and/or increase the qualified retirement options available to all partners. These plans eliminate the funding problem, while at the same time creating a retirement mechanism upon which all partners can rely as they progress through their careers. A qualified retirement plan is one in which taxes are deferred on contributions and earnings until withdrawn. They are typically self-funded. Such plans must comply with ERISA, which has complex and specific non-discrimination rules and other safeguards to protect employee benefits. Firms considering such plans can choose from a variety of qualified plan options, including: 401K Plan. A 401K plan is a form of deferred compensation. Annual contributions are made by the employee, employer, or both where the employer matches a percentage of the employee contributions. Contributions are not taxed until the employee receives distributions. There are penalties for withdrawals before the age of 59½. Contributions grow and accumulate until withdrawal on a pre-tax basis. Profit Sharing Plan. A Profit Sharing Plan allows a partnership to supplement other qualified or non-qualified retirement plans by giving employees a certain share in the 4

5 profits. The contributions are, for the most part, at the discretion of the firm. However, if contributions are made, they must be on a non-discriminatory basis. Any plan which rewards a small sector of the firm at the expense of other firm sectors, will not pass antidiscrimination tests. Pension Plans. There are basically two qualified pension options: Defined benefit plans, which provide for retirement benefits based upon a formula (usually years of service x average salary x a percentage) and defined contribution plans, which require the firm to contribute a specific amount to the plans. Typically, employees are also required to make contributions to a defined contribution plan. Defined benefit plans are rarely used in law firms, because they require the partnership to contribute to the plan on a regular basis to insure that there will be sufficient monies in the retirement account to pay the benefits as employees retire. Under a defined benefit plan, the partnership bears the entire risk of having sufficient funds to pay the defined benefits. On the other hand, in a defined contribution plan, employees are typically required to also make contributions. Typically, each employee has a retirement account and has available at retirement only the money left in that account. Thus, the individual partner would bear or share in the investment risk as well as the contribution risk. Most law firms outsource the management of qualified plans to professionals. To be tax qualified, a retirement plan must be designated and documented in compliance with IRS requirements. As noted, there are a variety of technical requirements under ERISA, including rules regarding plan design, documentation, the fiduciary responsibilities of the plan managers, reporting to the IRS and the Department of Labor, as well as disclosures to participants and beneficiaries. These requirements are usually beyond the capabilities of a law firm CFO, benefits administrator, or a full-time lawyer who has been assigned responsibility for overseeing the retirement plan by the firm. Summary Unfunded retirement obligations are a common pitfall for law firms. As law firms grow and age, they need to address the appropriate mix of qualified and unqualified plans that meet the needs of the firm, while at the same time rewarding those partners who have given so much to the law firm. MKT\NA\