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Current Trends in Partner Compensation

(Editor's Note: This article was excerpted from a presentation made to the Northern California Association of Defense Counsel on May 20, 1994. Several of our firm's principals, including John P. Weil, John D. Moore and Joseph R. Jacques participated in the seminar. We welcome your questions and/or comments on the article.)

The significance of compensation in the overall operation and success of a law firm can be summarized as follows: 1) Compensation is one of the most significant factors and one over which you as members of your firm have a great amount of control; 2) Other important factors include: being in the "right" field of law for the time, geographic location, and having the flexibility to adjust firm size for general economic conditions.

The objectives and benefits of a proper compensation system can be summarized as follows: 1) Promotes harmony among the partners because they feel they are fairly compensated relative to each other; 2) Minimizes dissatisfaction with compensation and departure of valuable partners; 3) Is attractive to capable senior associates so that they wish to become partners in your firm; 4) Provides an incentive for productive partners to stay with your firm to normal retirement age.

Partner compensation is affected by more than just a firm's specific compensation system for its partners. These factors include: 1) General economic conditions and government regulation; 2) Specific economic trends affecting the legal profession; 3) Compensation of associate attorneys, paralegals, and support staff; 4) Trends in advancement to partnership and establishment of partner "classes"; 5) Retirement obligations of the firm.

One of the most significant changes we as consultants have observed in the legal profession has been what we refer to as the "maturing of the marketplace for legal services." Briefly we can define "maturing of a market" as a change in the balance between service demand and the number of service providers the point where the service providers eventually balance or exceed the demand for their services. Let's look at some statistics.

In 1972 there were approximately 350,000 lawyers in the U.S. The American Bar Foundation estimates that by the year 2000, there will be 1,000,000 practicing attorneys. This translates to having one lawyer for every 572 persons in the U.S. in 1970 to having one attorney for every 275 persons by the year 2000. Literally a doubling of the relative number of lawyers from 1970 to 2000.

We remember times when law firms grew like topsy. Most of our clients wanted help to become more efficient in handling ever-increasing workloads. Any associate who had reasonably good legal skills and was willing to work would most likely make partner. Associates were not encouraged (or were even discouraged) to do business development because the partners in many firms had too many lucrative and important cases that needed handling.

Firms grew rapidly resulting in partner/associate ratios which provided ample income for the partners. There was enough income so that even relatively low producing partners could be well paid. Retirement benefits for the relatively few lawyers who retired during this period often were exceedingly generous.

The 1970's and 80's also witnessed a rapid escalation of law firm overhead. Overhead per lawyer in Calif. ballooned from $31,000 (40.59%) in 1976 to $144,000 (47.8%) in 1992 led by substantial increases in such items as office rent, staff salaries, office equipment, and malpractice insurance.

Favorable law firm economics also resulted in a bidding war for top law school graduates. Even though this took place mainly on Wall Street and with major metropolitan firms, its effect radiated down to small and medium-sized firms in most every legal field. Average starting salary 1977=$18,000; 1992=$50,000.

Thus, starting salaries for newly hired lawyers in private law firms increased 178% in the 15 year period from 1977 to 1992. At the same time compensation of partners increased only 138% from $64,700 to $154,200. Among the partner ranks, the most senior group (25-29 years of experience) saw a mere 118% increase in compensation from $88,450 in 1977 to $192,500 in 1992. This is data for the entire U.S., not just California. While the foregoing changes occurred, the CPI increased 131.5% from 1977 to 1992 [60.6 to 140.3].

Can we conclude from this data that average partner income approximately kept pace with inflation - a 138% increase in U.S. income compared with an 131% increase in the consumer price index? The answer is "not exactly". In 1976 average client hours worked by U.S. law firm partners was reported at 1,557 hours. By 1992 average client hours worked by partners had risen to 1,721, an increase of about 10%. Thus, average partner income has kept up with the CPI but lawyers have had to work harder and smarter to keep up.

There was still another notable aspect to law practice prior to the 1980's. We saw relatively little movement of capable senior lawyers among firms. Perhaps "raiding" was considered "ungentlemanly" and many firms had no need to entice "top producers" away from other firms. Oh how things have changed!!

The maturing marketplace for legal services has resulted in the following: 1) Heightened awareness for the need to "market" or "sell" a firm's services; 2) Has caused firms to abandon traditional seniority oriented compensation systems in favor of more performance oriented compensation plans; 3) Given more leverage for compensation to partners who are rainmakers; 4) Has facilitated the ability of capable lawyers (especially those who control books of business) to change firms if they are unhappy; 5) It has lengthened the service time for associates to become partners and has (in some instances) raised the qualifications for partnership; 6) It has caused some firms to set-up classes of partners and/or to establish permanent non-partner professional positions; and 7) Caused a review of retirement benefits in some firms.

In addition to the maturing of the legal marketplace which we have just described, general economic conditions during the past several years have not been very kind to lawyers. The insurance defense business generally has suffered along with such other legal fields as real estate, mergers and acquisitions, and corporate transactional work. There has been increasing pressure by many of your clients for you to hold down rate increases, and to absorb or reduce certain costs which traditionally have been passed through to clients.

Competition has become fierce with frequent strong courting of your clients by competitor law firms or break-away groups. Your type of practice may be particularly vulnerable due to the nature of your clients and the pressure which is exerted on the people who give you business to hold down legal fees and expenses. That's our impression of the general trends we see in your business. Now, let's look at some trends related to lawyer compensation and thus, partner earnings.

Starting salaries for new lawyers have leveled off. Above we reported that the average starting salary for new attorneys was $50,000 in 1992. The 1992 average was the same which was reported for 1991, 1990 and 1989. Thus, during the past four years there has been little or no increase in starting salaries. Today's law school graduates are being forced to compete with more experienced lawyers who have lost their jobs due to layoffs and cutbacks.

For many years, the rapid acceleration of starting salaries drove up other associate salaries. The pressure mostly is gone. Unless an associate has unusual abilities and connections, the threat of losing him/her due to perceived compensation inequities are much diminished in today's legal market.

For many firms, lengthening the service requirements for partnership has helped to increase or maintain partner income in today's competitive legal world. We always have noted considerable disparities in the length of time it took to become a partner in various law firms. We used to observe that the average small to medium-sized firm - say 10 to 25 lawyers, would have a 5 year service requirement to be eligible for partnership. Some smaller firms would consider an associate after 4 years and large firms typically had a 6 or 7 year service requirement.

During the past few years, we have seen a lengthening of these service requirements by about 1 1/2 to 2 years. Six to seven years now is the norm for smaller firms with larger firms requiring up to 9, 10 or even 11 years service. Naturally, all of this changes for the associate with unusual talent in the way of client and business development. The time truly has come in the legal profession where the ability to attract clients and new business is a most important factor in making partner and obtaining a relatively larger share of the income pie. In fact, we have seen a few instances where, regardless of other capabilities, an associate must display a willingness and some ability to develop new business in order to be made partner.

What then happens to associates who don't have this ability? Or others who have good legal skills but are judged incapable of carrying out the total responsibilities of a partner? In recent years we have seen some trend in the Western United States law firms for creating "permanent associate" positions, but we can't say that this trend is a strong one. However, it definitely makes sense in some instances.

Consider two examples: a talented lawyer who strictly wants to work 8 to 5 and their nature of work permits this; a senior lawyer who may have retired from a corporation.

In recent years we have seen considerable interest by some firms (usually larger ones) in exploring the merits of two-tier or multiple tier partnerships. However, here again we would not say that this has become a "trend".

Mostly we see "non-equity" partners, or an intermediate step (2 years). For those of you who wish to explore such a structure, we would suggest that you consider the following aspects of working in a law firm: 1) Capital contribution - non-equity partners (are they really partners?); 2) Status (how are they presented to the public and your clients); 3) Income (less) but why need separate "class" for this?; 4) Voice in management; 5) Retirement benefits; 6) Liability.

Who are the intended beneficiaries of a multiple tiered partnership? Can these benefits be obtained in the framework of a regular partnership? If yes, which partners go to a tiered arrangement?

Before we proceed to discuss the trends in how income is divided among active partners, lets briefly look at trends in retirement benefits as this too is part of the compensation picture.

We can report to you that there is a definite trend toward the reduction of retirement benefits or outright elimination of such benefits in some firms. The reasons for this are as follows:

1) Changing demographics are giving rise to potentially large unfunded retirement obligations. Reluctance of younger partners to pay these benefits; 2) Diminished need of lawyers for retirement benefits due to their own build-up of Keogh plan assets or in similar corporate type qualified pension plans.

How much money are we talking about? Before the current trend set in towards reducing or eliminating retirement benefits, the most common retirement benefit we saw in law firms was one year's income for the retiring partner. This varied between a low of say 3 month's income up to 2 1/2 years' of income. But one year was typical, so that on today's scale of partner earnings you may have been talking in the $200 to $300K range. Potentially, this may be quite a loss for partner's whose firm's are phasing out retirement benefits.

If future, unfunded retirement obligations are of concern to your firm you may want to explore some alternatives, such as paying off these obligations currently on a present value basis. Alternatively you may want to at least put some restriction on total annual retirement payouts in your partnership agreement. (Editor's Note: If you don't have such a clause now, and wish to consider such a step, give us a call and we'll be pleased to send you some sample language of such a restricting clause.)

So far we have talked about peripheral compensation issues. Now lets talk about trends in compensation arrangements for active partners. The main trend here has been a movement toward paying increased attention to partner performance and adjusting compensation commensurately. And quite frequently, we hear of firms which actually have terminated or separated some of their presumably "unproductive" partners.

During the past ten years, we as consultants have been called on quite frequently to assist firms in changing from compensation systems which were heavily oriented toward seniority to systems in which partner performance plays a much grater part. We feel confident in asserting that many of your firms probably have made this type of change in your partner compensation system in recent years.

At this time, let us review briefly the basic types of partner compensation systems which exist among law firms: 1) Seniority based systems - lockstep; 2) Performance based systems - subjectively measured; 3) Performance based systems - objectively measured; 4) Tiered systems and combination systems.

When we entered the legal consulting business, there were many firms which had essentially seniority based systems. Many were not as strictly defined in terms of progression as a lockstep system, but they were seniority based systems - that is a partner's length of service with the firm carried great weight in determining compensation. Other factors, namely productivity and business generation, were considered but these were not the dominant factors.

Firms where performance was a greater determinant in compensation usually had annual or biannual meetings of the partners to review performance and negotiate income percentages. In many cases, these meetings would become extremely divisive as partners would criticize each other publicly. In larger firms, compensation committees would be set up to assess partners' performance and make compensation recommendations. A less divisive method of determining compensation - but still a system in which performance is subjectively perceived.

The late 60's and early 70's saw the broader use of performance based systems in which attempts were made to measure performance via accounting data. Usually, these systems were not successful and we see relatively few of them today.

As the marketplace for legal services matured, and competition for bright lawyers who controlled a book of business increased, firms with traditional lockstep compensation plans found that either changes had to be made or productive partners (mostly middle partners) would leave. Rather than outrightly abandoning their traditional compensation systems, firms often added bonus pools whose distribution was tied to individual performance. Another feature which was frequently added to lockstep plans was the setting up of defined performance goals which had to be met in order to progress beyond certain steps on the income progression ladder.

Of all of the various approaches to partner compensation which we have seen, we could not say that one approach is better than another. We would judge the merits of any compensation system based on the following criteria: 1) Is it perceived to be fair?; 2) Does it recognize all types of contributions to the firm's success?; 3) Does it encourage specialization?; 4) Is it understood by those subject to it?; 5) Does it motivate individuals to behave in a manner which furthers the firm's goals and objectives?; 6) Is it flexible to meet changing needs of the firm?; 7) It is generally not desirable to have small differentials in compensation.

Test your own firm's partner compensation system by applying these criteria: If you get one or more "no" answers to these six questions, its time to consider some changes.

Because the trend in partner compensation is toward performance based systems, let's look at the essential elements that such a system must have: 1) Performance must be properly defined. What factors? What relative importance? Do not use more than 6 or 7 factors. Some factors overlap: i.e., business origination and business perpetuation; administrative responsibility and associate training; 2) Performance must be measured and/or judged i.e., use of data and time records. Many factors can only be judged subjectively; 3) Both long-term and short-term performance should be considered; 4) A mechanism must be developed to translate performance ratings into compensation levels; 5) Partners should receive sufficient feedback to know which aspects of their performance are strong and which require improvement.

If all of these sound easy, let us assure you that it isn't. Lets take another look at the four elements which are mentioned above: 1) What factors and what weight. List factors and ask each partner to give his/her opinion relative to the importance of each factor, scale 1 to 10. Some factors rated from 1 to 10; 2) Measuring performance is very difficult. Even with proper financial and management reports. Other factors only can be measured subjectively. Attempts to credit specific partners for business origination can lead to conflicting claims; 3) It is difficult to do mechanically. Small variances in compensation between partners usually are not healthy; 4) Feedback must be given without identifying specific critics. Criticism can't be softpedaled.

Here are some aids in developing and/or using performance ratings: Structured vs. Unstructured Performance Rating. Examples:

Unstructured

Rate each partners' total, overall performance on a scale of 1 to 10 (5 should be average).

Structured

Rate each partner on 7 performance factors on a scale of 1 to 10 (5 average). Add 7 individual scores to give a total performance score. Or multiply each rating by a factor which reflects the importance of that performance element. Then add resulting scores. Use empirical formula for translating performance scores into compensation. Set compensation levels which have meaningful differentials. Number of levels depend on size of firm. Compensation levels should differ by 10% to 20% for most firms. Define levels by assignment of points, not dollars.

Hopefully, when you have done this you'll have a system which will promote the success of your firm and make everyone happy? Is this possible? All partners happy with their compensation? Probably not! Some partners always will refuse to see themselves in the light in which their partners see them. Some only will grouse - others will leave the firm.


Copyright 1994 - 1998 John P. Weil & Company