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Deferred Compensation: How to Mitigate the Risks of an Unfunded Plan

3/23/2017 - By Zachary Farrington

 The past can come back to haunt law firms that made promises to provide retired partners with substantial incomes, sometimes for life. Often, these promises of future benefits were made back in the “old days” when firms were smaller, partner incomes were lower and “for life” didn’t mean as long as it does now.

The problem with these deferred compensation arrangements is that they were often made without funding. Earning partners then became burdened by cash flow obligations to retired partners. The resulting impact on future profits can lead to some worrisome consequences, including these:

  • Established partners leave. Established partners may choose to leave the firm — and take their clients with them — simply to avoid these payment obligations. 
  • Potential partners are wary. New partners and new or lateral associates may be scared off knowing their income might be saddled for years.
  • Merger candidates balk. The presence of unfunded plans can be a deal-breaker when acquiring another firm or becoming a merger candidate yourself.

Limiting the Risks

Short of terminating the plan, partners may need to modify an unfunded plan to limit the firm’s exposure. Some strategies to consider include the following:

Cap it. Consider capping the total amount of retiree payments to a percentage of current earnings. Or, you could cap the amount of individual retirement payments in any one year. This will protect the firm’s cash flow if several partners retire within a short time.

Shift it. Begin shifting unfunded obligations to a funded plan, such as a 401(k), profit sharing or defined benefit plan. This eliminates the funding problem while creating a retirement mechanism that all partners can rely on as they progress through their careers. 

Consider establishing a cutoff or grandfathered age for partners on a graduated basis. In other words, the more time a partner has to accumulate assets in a funded plan, the less vesting in the old unfunded plan he or she will have. 

Buy them out. In good years, use cash to buy out the obligations of retirees — on a voluntary basis and at a reasonable discounted net present value. This allows the firm to reduce its future obligations and provides retirees with the security of a lump sum in exchange for the discount.

Require notice. The firm can better prepare economically if a retiring partner is required to give three, five or seven years notice of his or her intent to retiree.

Be aware that amending an existing deferred compensation plan requires not only the consent of participants, but also compliance with Internal Revenue Code Section 409A.

Funding the Obligation 

Of course, one other solution is simply to fund the obligation. That said, partners will need to carefully consider the best option for doing so. For example, setting aside money now to fund future retirement obligations will result in partners paying tax on the “undistributed income.” The monies set aside are generally treated as taxable income to the firm in the year in which the income was earned. 

Funding the deferred obligation as it becomes due is another option. Paying as you go from current cash flow sidesteps some of the tax issues, but does so at the cost of limiting the income available for distribution to the remaining partners. 

With a longer horizon, you may decide to purchase a financial product to help fund the obligation — such as a single premium immediate annuity (SPIA) or cash value life insurance. Here, special attention must be paid to ownership, beneficiary and payee designations to avoid creating taxable income to the participant prior to the desired time of distribution. 

A Mixed Blessing?

Unfunded retirement plans offer some advantages to partners, including the ability to maximize current income and the potential for substantial returns at retirement. But there is also some potential downside, including the possibility the money may not be there when partners retire. 

Savvy partners will address this challenge with the appropriate mix of qualified and unqualified plans. The best strategy will limit the firm’s exposure to unfunded obligations while rewarding retiring partners for their hard work and contributions. .

Our professionals are experienced in the unique demands of law firms just like yours. Contact a member of our Litigation Support team if you have any questions.

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