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  • It Works Until It Doesn’t – Service Firm Pensions

    Posted by Carl from Chicago on March 6th, 2012 (All posts by )

    I spent many years in the consultancy / accounting industry, which has many similarities to the business model for legal firms. They are both 1) primarily based on hourly billing rates for their income 2) use a pyramid or partnership structure with the top members often receiving an equity or ownership stake 3) have partners who need to seek out business in order to keep the revenues flowing. If you are interested in this industry, I highly recommend reading “Managing the Professional Services Firm” by David Maister, a timeless book on the topic.

    The Wall Street Journal had an article recently titled “Next Pension Clash: Law Firms” with the subtitle “Unfunded plans burden younger partners, but build loyalty among small group”.

    At some of the country’s top firms, younger lawyers will foot the bill for deluxe pension plans that could drag down their own earnings for years to come… these pensions are largely unfunded. Partners at some elite firms are often entitled to between 20% and 30% of their peak pay after retirement – in many cases, for life… that could mean payments of $400,000 to $600,000 per retired lawyer.

    One of my friends who is a partner in a professional services firm once told me that he’d never tell his son to go into a business where he was “selling his time”. While there are many other attributes (a senior person is selling his time AND his ability to manage and supervise staff), there is a lot of truth to this quote.

    Thus the partner, who was well compensated while he was at the firm, is now going to collect a pension in the future, while he is no longer contributing to the ongoing revenues of the firm. It is true that the client relationships that the partner built up (and left behind) are valuable to the firm, along with any specialties that the partner built up (and trained staff on), but the bottom line is that most of that revenue stream is up for grabs soon after the partner is gone. Even if the clients are left in good shape and well transitioned, if the NEXT partner doesn’t do a good job, all that goodwill is drained very quickly.

    Like all unfunded pension schemes – it is really a “bet” on the future, on an era of rising prosperity, and a bet that paid off for a generation of retired lawyers. For those coming up the ranks, however, the future of course looks more uncertain, with more vicious competition and increasing use of offshore resources for more mundane matters, which both can be a source of short term profits as well as a long term threat of cannibalization of higher margin revenues up the chain.

    It seems like these sorts of burdens would turn off rising lawyers, who have the ability to “jump ship” quite easily since non-compete laws generally don’t apply to lawyers, from what I understand (it is interesting how those that write the laws that entangle everyone else managed to develop an escape hatch for themselves). These sorts of payouts, which come out of partner profits after all expenses have been allocated, can be significant in harder times.

    Traditional pensions are also under intense pressure, especially since the “rate of return” assumptions are being reduced with the Fed’s extremely low interest rates. This article sums up how corporations are asking for relief:

    The latest bid is spurred by the effects of the Federal Reserve’s low interest-rate policy, which has led to soaring pension liabilities.

    While the companies are basically arguing that interest rates are artificially low and that their funding requirements shouldn’t surge as a result, the unstated point is that returns for EVERYONE have gone down, as well. Many models for investors in 401k plans used to assume 10% rates of return indefinitely; given market volatility and flat returns over the last DECADE, 10% / year seems ridiculous to investors of all stripes.

    The pension firms in this article often have different challenges because they are often unfunded and totally dependent on future revenue streams; in this sense at least they are immune from the Fed’s zero interest rate policy distortions.

    Cross posted at LITGM

     

    6 Responses to “It Works Until It Doesn’t – Service Firm Pensions”

    1. Michael Kennedy Says:

      The same problem applies to surgeon partnerships. This has been a problem in the past where the retiring senior partner expected to be compensated for good will. It has resulted in a number of surgery partnerships breaking up with younger partners going on their own. In some ways, that is not as easy now since contracts are often in the senior partner’s name. When I retired after back surgery, I had 176 plus or minus contracts with various insurance companies and HMOs. The younger surgeon I took in could not have gotten those contracts himself. Since I was leaving early, because of surgery for a chronic back problem, he inherited them as part of the deal to buy me out. He neatly avoided the cost by declaring bankruptcy a month after collecting $11,000 the previous month. Trust in professional relationships is important. He was divorcing his wife but miscalculated and has had a tough time since. I think he is now in Arkansas.

    2. Bill Waddell Says:

      Everyone who has a job is basically “selling his time”; and every person who sits in a cubicle or works in front of a machine has to create enough value to pay for excessive pensions, bloated management compensatin packages, government waste and all manner of nonsense that has nothing to do with the person doing the work. The line of sight between the lower level worker and the payments for such is just a little clearer in a professional service firm, but it is exactly the same no matter what the job or the nature of the firm may be.

    3. Bill Brandt Says:

      Interesting Carl and reflects the problem with many pensions in other industries. They cannot be sustained.

      But for this to happen to an accounting firm – is like the fortune teller near my house who – went out of business.

    4. Jonathan Says:

      The problem with selling your time is that leverage is limited. You get around that issue to some degree if you are the top of a pyramid as in law firms. It is better to have equity in the form of either a stake in a manufacturing process (broadly defined — this could also mean writing books or selling art) or as an owner of options (broadly defined as claims on things that have a chance to grow in value). Even if all that you own is a hot-dog stand you are in some ways better off than the well-paid law-firm associate or corporate employee, because you have complete control, which gives more options. The older you get, the more important control becomes because the less time you have left to recover from other people’s accidents and mistakes.

    5. VictorWhatsYourVector Says:

      Small service firms are never worth much more than the receivables and the assets.

      The true value resides within the personal relationships of the individuals that will carry on.

      Exorbitant retirement packages, buy-out plans, etc. only invite “reorganization”…

    6. Bill Brandt Says:

      @VictorWhatsYourVector

      How true that is. When a restaurant or automotive repair shop changes hands it is like a whole new business – and you have to reevaluate whether it is worth your continued patronizing.

      A restaurant’s persona is the chef and the repair shop – the owner and the mechanics working for him. I have seen both change hands and the difference is like night and day.

      Usually not for the better ;-)