A Burden - American Business Media

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A Burden
A remnant of a simpler time, the generous
pension plans at many Am Law 100 firms place
an increasing weight on younger partners.
Is a generational battle looming
By Julie Triedman
P h o t o g r a p h By Fr e d r i k Br o d e n
photo credit feet in
It’s a safe betthat
partners at Simpson Thacher & Bartlett aren’t lying awake
at night worrying about their 401(k)s. No matter what happens to the stock market, they’re guaranteed
to retire rich, thanks to the firm’s pension plan.
The plan—the most generous among 21 Am Law 100 pension plans we analyzed for this article—promises
retired partners a quarter of the compensation they received during their highestearning
years. For life. On top of that, retirees receive an additional payout of 130 percent of
that highest-compensation average, spread out over seven years. Currently, 30 retired Simpson
partners are receiving these pension benefits.
Benefits under Simpson’s plan, like those of other Am Law 100 firms with traditional unfunded
pension programs, are paid for out of current income. And because Simpson, like other Am
Law 100 firms, has steadily expanded the size of its partnership since the plan was created, we
wondered how much it will cost the firm over the next decade or so, as a glut of those it elevated
to partner in the seventies and eighties retire.
The answer: a lot. Our hypothetical, back-of-the-envelope calculation of Simpson’s future
liability—which we believe can stand in for at least a dozen similarly situated firms—indicates
that it will be paying out of its annual income a minimum of roughly $65 million a year by 2022,
double the estimated current annual payout. (We asked Simpson chairman Philip “Pete” Ruegger
III to correct or comment on our numbers. He declined.)
A scan of the firm’s 194 partners reveals that approximately a quarter could be expected to
72 May 2009 | americanlawyer.com
The American Lawyer | March 2012 73

etire by 2022, providing that most do so around the firm’s
normal retirement age of 62. Assuming a handful die early,
the firm may see 43 new full-freight retirees within the
decade. Assuming that this batch of senior partners have
been earning $3.5 million during their highest-compensated
years—a conservative estimate, consultants say, at a
firm that posted average profits per partner of $2.6 million
in 2010—a soon-to-retire partner can expect roughly
$875,000 a year in benefits, plus roughly $650,000 in each
of the first seven years from the additional distribution
(subtracting roughly $50,000 offset by another defined
benefit plan funded by the firm). Over the decade, the
firm’s annual liability gradually creeps up to roughly $65
million for the new retirees by 2022, not including benefits
for those already in retirement. But as long as the firm
increases its net by about 3–4 percent a year (since 2000,
PPP has grown an average of 4.68 percent annually), the
drag on profits will remain just about what it is now.
At Simpson and many other Am Law 200 firms, pensions
are the elephant in the room. Several firms continue to guarantee
their equity partners far richer pension plans than they
probably should. And that future pension liability is growing
at a time when it is looking less than certain that profits and
partner head count will grow in step with them.
The recession, with its double whammy of retirement
investment portfolio declines and firm revenue slowdowns,
was a broad wake-up call for firms that fund pensions out
of current income, as well as for the broader swath of firms
a pensions primer
The fine print about how firm retirement plans work.
Until 1987, the Internal Revenue Service
didn’t allow firms to put more than
$7,500 per partner into tax-advantaged
pension plans each year. In 2000 and
2002 the IRS sharply increased the
amounts that firms could set aside in
defined benefit programs, and many law
firms adopted the new plans as an alternative
to their then common unfunded
plans. Currently the maximum retiree
benefit permitted under the tax-advantaged
plans is $200,000; it rises yearly
with the cost of living. (Non-tax-advantaged
plans continue to have no benefit
or contribution limits.)
Here is a guide to what many firms
now offer:
Defined benefit plan This is an
umbrella term for any plan where the
annual retirement benefit is determined
by a set formula, including traditional
plans and the newer-generation cash
balance and variable-annuity plans. The
formula establishing the benefit may
incorporate past compensation, years
of employment, age at retirement, and
other factors.
Cash balance plan Sometimes
called a “partner parity” plan, this is
a defined benefit plan that looks like a
bank account. Traditionally, each partner
has a notional retirement account where
interest is credited on the basis of an
external index, such as a Treasury rate.
The firm pays a contribution annually,
charged back to the current partners,
to fund the plan up to a defined target
or level of “pay credit” (usually based on
deferred compensation). If the investment
gains do not meet the external
interest rate returns credited to each
partner’s account, the firm—and indirectly,
the current partners—must make
an additional contribution to top up the
investment pool.
Market-rate cash balance plan
This IRS–approved plan, which is permitted
as of October 2010, allows retirement
annuity levels to fluctuate along
with the actual return on a firm’s investment
portfolio, thus reducing the possibility
of a shortfall. A similar plan that
allows payouts to fluctuate is known as
a “variable annuity.”
—J.T.
that fund benefits out of firm-run investment portfolios.
Many in the latter category had to dig into earnings to
cover shortfalls in guaranteed benefits funded by firm investments.
But the problems created by the sagging economy
brought into relief a bigger, looming issue: The ranks
of retired partners is swelling just as the number of equity
partners—who are ultimately responsible for funding the
pension plans—is leveling off. “This is an issue that cuts
across all regions and all sizes of firms,” says Dan DiPietro,
chair of the Law Firm Group of Citi Private Bank. “It’s a
generational issue: As firms face the bubble of baby-boomer
partner retirement, the problem will only get bigger.”
The firms facing the largest future liability are the Am
Law 100 firms with rich guaranteed benefits paid out of current
income. We independently obtained information about
the plans currently or recently active at 15 of the top 50
Am Law 100 firms [see “Retiring in Style,” page 77]. All but
two—Sullivan & Cromwell and Weil, Gotshal & Manges—
offered unfunded pension plans. We shared our information
with each firm and offered them the chance to update it;
only five chose to do so. For the rest, we corroborated the
information independently to the extent possible.
Many partners we interviewed told us they had little
knowledge or understanding of their benefit plans or
their firms’ financial liabilities. But it’s not surprising
that some firms aren’t being open with their partnership:
Unfunded plans, in particular, tend to divide partnerships
along generational lines. “Younger partners
are saying, ‘I’m never going to see the money; I’m paying
to guys who were here when I was in high school,’ ”
says Bradford Hildebrandt, president of Hildebrandt Consulting
LLC. “Then you have guys who are about to retire
who are saying, ‘Are you kidding me You owe it to me.’ ”
It’s a division that will only intensify with time. Simple
demographics dictate that payouts to retired partners will
be an increasing weight on profits for at least the next decade,
and maybe two. “The 45-year-old types are enormously
productive and are diverting money to satisfy 68-
year-olds,” says Peter Kalis, chair of K&L Gates, a firm
that phased out its unfunded plan in the late 1980s. “When
those [younger partners] are attracted to go to firms without
that overhang, that business model [of the firm with
the pension] fails. That day may never come, but it’s important
to consider.”
Historically, In 1997
many firms set up unfunded
plans. Many of these plans are still in place, though
often current partners are no longer accruing benefits under
them. “The theory was that these partners built the
firm, and we owe it to them,” says Hildebrandt. There is
no mechanism for funding; retired partners’ pension benefits
are scooped out of the firm’s current profits—in much
the way that Social Security payouts are funded by payroll
contributions from current workers.
Generally, it is the lockstep or modified lockstep firms
that still embrace unfunded plans. At these firms the benefit
is usually calculated as a percentage of compensation,
typically 20–30 percent of the average of a retiring partner’s
highest-compensation years. Partners vest in the plans
after 20–30 years of equity partnership, though in some
cases partners can partially vest in as few as ten.
Firm leaders describe these unfunded plans as golden
handcuffs. Noncompete clauses built into nearly all the unfunded
plans mean that partners lose their pensions if they
join another firm [see “Taking It with You,” right]. As a partner
approaches the age of 48 or 49, with vesting just around
the corner, it becomes hard to leave. “Those of us who have
been seeing our net income get hit every year are looking
forward to receiving [the pension],” says one senior partner.
Because benefit levels are linked to a partner’s highestearning
years, payouts have ballooned, as the Simpson example
shows. In the early to mid-nineties, senior partners
at the most profitable firms earned around $1 million; a 30
percent annual benefit of $300,000 might have been typical.
But these days, senior partners at the most profitable
Wall Street firms may take home $3–4.5 million a year,
generating an entitlement of $1 million or more for life.
“They’re making a fortune in their retirements,” says consultant
Peter Zeughauser, chair of the Zeughauser Group.
“There are many who are making more in retirement than
they ever imagined.”
Such plans assume a level of confidence in future financial
performance. “Our plan works as long as the firm
continues to grow profitably,” says Thomas Reid, managing
partner of Davis Polk & Wardwell, which guarantees
partners 30 percent of their highest compensation years
for life. “We have a handle on our demographic in terms
of who is approaching retirement. We have sufficient associates
moving toward partnership, and we’re confident that
retiring partners can be replaced without any adverse impact
on profitability. I know there are some firms that have
struggled with this, but it’s not an issue for us.”
Some younger partners at the firms with unfunded
plans, however, lament the drain on their current income,
and many also worry that their firms’ business strategies
are increasingly driven by the need to fund partner retirement.
An unfunded plan “puts a huge onus on the firm,”
says a partner at a firm with a generous plan who spoke on
condition that he and his firm not be identified. “It forces
you . . . to grow in order to pay the pension fund.”
Younger partners also express skepticism about the future
viability of unfunded plans. “Everyone understands
it’s a crapshoot,” one such partner wrote in an anonymous
flash survey we conducted in January on this topic. “It is, in
effect, deferred compensation.”
the Internal Revenue Service began
allowing firms to establish prefunded, tax-advantaged defined
benefit plans. Under these plans, firms invest a portion
of current income in a firm-managed portfolio each
year, with the contributions and investment proceeds
dedicated to funding future retirement payouts. The plans
looked more like 401(k) plans—partners were assigned notional
“accounts” that are credited with a set growth rate—
but just like pension plans, they guarantee a benefit [see “A
Pensions Primer,” page 74].
Additional IRS changes in 2000 and 2002 substantially
increased the maximum individual annual benefit under
these plans. (For 2012 the maximum per retiree under an
IRS–approved defined benefit plan is $200,000 a year; the
annual contribution limit under defined contribution plans
like the Keogh or HR.10 plans is $50,000; and for 401(k)
plans, $17,000.) Increasingly, a combination of IRS–qualified
plans began to look like an attractive alternative to the
unfunded plans, says Philip Deitch, a partner at PricewaterhouseCoopers
LLP who specializes in law firm actuarial
planning. Firms hoped to thereby eventually avoid having
Taking It with You
Lateral movement can complicate the pensions picture.
Last year saw a strong increase
in lateral movement among Am Law 200
firms. It’s a trend that’s unlikely to slow.
But what happens to a partner’s retirement
benefits when he or she joins another
firm
Any vested money in IRS–approved
plans, whether defined contribution plans
like 401(k)s, Keoghs, or defined benefit
plans like cash balance or variable annuity
plans, is safe. A partner keeps those
assets and can roll them over into an Individual
Retirement Account.
But for partners leaving or joining
firms with unfunded plans, the situation
is more complicated. Typically, laterals
who join firms with active unfunded pension
systems have the most to gain: They
are folded into their new firm’s plan after
achieving a specified amount of tenure.
Conversely, partners who leave firms
with the richest unfunded plans to join
new ones risk leaving a lot of money on
the table. While retiring early from those
firms may be encouraged—some firms
offer partners a reduced benefit beginning
at around ten years’ service as a
partner—firms with unfunded plans generally
have the right to cut off all benefits
if a partner joins a rival firm.
If lost benefits are an issue, hiring
firms often have ways to make a lateral
partner whole. “It really depends on ‘how
much does the firm want this partner’”
says Jon Lindsey, managing partner at
legal recruiting firm Major, Lindsey & Africa.
“You have to be creative to find a
way to make it work for both sides.”
At one extreme, firms have offered a
one-off payment to replace the net present
value of benefits that were forfeited;
LeBoeuf, Lamb, Greene & MacRae was
said to have awarded prominent litigation
partner Ralph Ferrera an $8 million
special payment to replace the Debevoise
& Plimpton pension he forfeited
when he joined that firm (now Dewey &
LeBoeuf) in 2005. (The firm declined to
comment.) In other cases, “a firm may
have to buy them an annuity that will
make up the bulk of lost benefits,” Lindsey
says. In some situations, he says, the
firm will make a loan, which is forgiven
over time to net out an equivalent sum
by the time a partner finally retires. Or
the firm may increase current compensation
enough for a partner to put aside
enough money to offset some or all of
the loss. Such arrangements are relatively
rare, and older partners or those
without a large and portable book of
business seldom receive them.
But disputes over terminated benefits
are on the rise, according to Arthur
Ciampi, a New York lawyer who represents
partners in litigating such disputes.
Many pension disputes arose during the
recession, when some firms eased out
partners who were on the cusp of vesting
and then cut off benefits, arguing
that those lawyers forfeited them when
some inevitably joined other firms.
Ciampi says his firm has handled
a half-dozen cases recently involving
breach of fiduciary duty and age-discrimination
claims; most such disputes are
settled. With the laws regarding age discrimination
in partnerships still in flux,
firms don’t want to risk a bad ruling.
Another type of dispute concerns
the validity of pension plan noncompete
provisions. Ciampi says that, while firms
are permitted to have such provisions
in plans that are considered genuine retirement
benefits, they sometimes are
inconsistent about who gets to keep the
benefits. In the course of reporting this
story, we were told of several instances
where firms permitted retired partners
to join smaller firms that they don’t consider
rivals without losing benefits; in
one case, however, when the small firm
was acquired by a larger firm, a retired
partner had to leave the merged firm
in order to retain the benefits from his
original firm.
“It can be a very scary time,” Ciampi
says. “You anticipate a benefit will be
there. You’re at a vulnerable time in your
career. This has now been taken away
from you. And when you try to replace
it, the plans are not available.” —J.T.
74 March 2012 | americanlawyer.com The American Lawyer | March 2012 75

Average number of equity partners
current partners fund retired partners’ benefits, though
they still have to pay for accrued benefits for many years.
Deitch estimates that about eight in ten Am Law 100 firms
now have some form of tax-qualified defined benefit plan.
But the plans, while enormously popular, are not necessarily
a panacea. “There are significant risks associated with
certain types of defined benefit plans,” most notably traditional
cash balance plans, says Deitch. Unlike in a 401(k),
the payout to individual partners in a cash balance plan is
not linked to the actual performance of the investments, but
to an external interest rate, such as a Treasury index rate. If
a firm’s investment portfolio underperforms that rate and
falls short of the amount needed to fund the guaranteed
level of benefits, partners have to make up the difference,
either out of current income or in years to come. Unless
firms adopt a stringent pay-as-you-go approach, “they risk
creating subsidies between . . . generations of partners,” says
Deitch.
Firms learned this, to their dismay, in 2008 and 2009,
when the balances in many firm-run retirement portfolios
fell by 20 percent or more, Deitch says. The problem was
especially acute at firms that had established non-tax-advantaged
plans with much higher guaranteed benefits than
the tax-advantaged plans. According to a senior partner
at a New York law firm, some firms had invested retirement
money in hedge funds, and these funds plummeted
in 2008–09, just as overall firm profits slid. “Everyone got
excited about hedge funds and their great returns” in the
1990s, when their returns beat the equity markets, this
partner says. “Well, that didn’t work out so well for us.”
In the first quarter of 2011, as part of its annual Law
Watch survey, Citi Private Bank asked its clients, a healthy
A Growing Obligation
The average size of Am Law 100 equity partnerships
has doubled since 1986, leaving some firms’ pension plans
struggling to keep pace.
200
150
100
50
0
1986
1991
1996
2001
2006
2010*
*Most recent figure available. Includes worldwide equity partner counts for vereins.
Source: ALM Legal Intelligence (Am Law 100 Survey)
proportion of Am Law 200 firms, about their obligations
to retired partners. Roughly 40 percent of firms, including
those with unfunded and underfunded pension liabilities,
projected a shortfall between future obligations to retired
partners and funds firms had allocated to pay for them;
those indicating some shortfall included 21 of the Am Law
50 firms that report to the bank, and 23 of the Am Law
51–100 firms. Among firms that projected a shortfall, Citi
determined that the gap between future funds available
and projected aggregate payouts to retirees ranged widely—from
less than $1 million for some firms to more than
$100 million for others; Citi did not disclose the average
amount of exposure.
Firms with
both unfunded pension
plans and the newer defined benefit plans generally have
moved to limit their annual liability by instituting caps on
the percentage of firm income that can be used to fund retirement
benefits in any single year. In researching this story
we found that caps usually ranged from 3 to 5 percent.
But for some firms with The Am Law 100’s highest profits
per partner, caps ranged between 10 and 15 percent, and
at one firm, Cahill Gordon & Reindel, the cap was 20 percent
as recently as 2007. (The firm declined to confirm or
update that information.)
In recent years many firms reduced their caps, we
learned. But the caps may lead to a false sense of security
that the firm has its financial obligations under control; in
reality, most plans bar firms from giving retired partners a
pension haircut even if the cap is surpassed. The cap simply
allows a firm to reduce pension payouts temporarily; it
then has to pay out the shortfall as soon as it can meet its
obligations without breaching the annual cap. Meanwhile,
overall future liability remains unaffected.
Though our reporting did not uncover any firm that
had breached its cap, several law firm financial consultants
and managing partners say that day is soon approaching
for many firms, given the demographic realities: Through
the nineties and well into the last decade, the size of equity
partnerships at Am Law 100 firms expanded rapidly.
But firms began applying the brakes in recent years [see “A
Growing Obligation,” left]. Firms will also be paying retired
partners longer: Average life expectancy is expected
to rise from 78 today to a projected 80 by 2020, according
to U.S. Census Bureau data. Never will so many retired
partners be supported by so relatively few active ones.
The future
challenges and future liabilities
for firms that have shifted to investment-funded
defined benefit plans (including both tax-advantaged and
non-tax-advantaged plans) are distinct from the firms with
unfunded plans. Since the 2008 recession, these firms have
been wrestling with how best to invest funds, and how
much to ante up now, to ensure that they can cover future
guaranteed benefits.
For firms with tax-advantaged plans, relief may be on
the way. In late 2010 the IRS approved a new kind of defined
benefit plan, called a market-rate cash balance plan,
that reduces investment risk. These plans for the first time
link benefit levels to actual investment continued on page 91
retiring in style
Many Am Law 100 firms maintain generous pension plans. Here are details of a sampling. Some firms were not willing to share current information on
their plans; in those cases, which are footnoted, we used the most recent available. Because it takes several years for any change in plans (such as a
freeze at current accrued benefit levels) to make a dent in future annual benefit payouts, we view even outdated information as germane.
Firm
Funding
mechanism
Formula for determining annual benefit,
duration of benefit, and years to vest
Cahill 1 None Fixed amount ($245,000 as of 2007).
For life. Vesting at 24 years.
Cleary 1 None 12% of what the partner earned in his last year
for first ten years of retirement, then 7.7% of the
last-year earnings. For life. Vesting at 20 years.
Cravath 2 None 25% of an average of the partner’s highestcompensation
years. For life. Vesting at 30 years,
including time as associate.
Davis Polk None 30% of the average of a partner’s three highestcompensated
years in the five years before
retirement. For life. Vesting at 20 years.
Debevoise 1 None 25% of average earnings in the ten years before
retirement. For life. Vesting at 20 years.
Foley & Lardner 1 None 25% of the average of the partner’s three
highest-compensation years. Duration: N/A.
Vesting at 30 years.
Fried, Frank 1 None Three benefit levels; as of 2007, they ranged
between $117,000–$175,000 a year.
Duration: Ten years. Vesting at 20 years.
Kaye Scholer 1 None Based on firm income; annual benefit was
$200,000 in 2007. For life. Vesting at 15 years.
Latham 3 None 36% of the average of the partner’s three
highest-compensation years for first five years
of retirement, then 24% of the same average.
Duration: Ten years. Vesting at 20 years.
Milbank 1 None 23% of the average of five of the highestcompensation
years in the last ten years of
service. Duration: N/A. Vesting at 20 years.
Paul, Weiss
Proskauer
Simpson Thacher
Sullivan & Cromwell
Weil, Gotshal
Partially offset
by funded plans
Partially offset
by funded plans
Partially offset
by funded plans
Funded through
firm investments
Partially funded
by firm investments
20% of the average of five of the highestcompensation
years in the last ten years of
service. For life. Vesting at 20 years.
0.5% per year of service, up to a maximum of
30 years. This service factor is multiplied by the
average of the partner’s eight highestcompensated
years, capped at $2 million as
of 2010. For life. Vesting at 30 years.
25% of the partner’s final-year compensation.
For life. Vesting at 20 years. Retired partners get
an additional equity payout of 130% of annual
income, paid out over seven years.
All retired partners receive the same amount
annually, which depends on the firm’s
contributions to its retirement fund and the
returns on the firm’s investments. Duration: N/A.
Based on a percentage of a partner’s highest
compensation, subject to a maximum individual
cap. For life. Vesting at 20 years.
1
As of 2007. 2 As of 2009. 3 As of 2011. N/A means that information was not available.
Cap on
firm net
20%
recent changes
10% In 2006, the firm reduced its cap to 10% from 15%
and introduced a haircut of 1–5% applicable to
senior partners.
15% A previous plan vested at 20 years of service.
15% Firm recently established a variable annuity plan.
10%
N/A
8%
4%