Retirement Planning For Law Partners
A Study of Trends and Tactics
F indings P resented B y
RCG
Benefits Group
August 2010
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Dear Colleague: RCG|Benefits Group is pleased to share with you the recent findings from our first annual Retirement Planning for Law Partners – A Study on Trends and Tactics. To our knowledge, this study is the first of its kind designed to review, assess and report the impact of firm practices on partner wealth accumulation. Why is this endeavor important? An estimated quarter-million Boomer lawyers are due to retire in 20111. This march forward is causing a flurry of retirement planning issues at law firms today, many of which do not have well-developed retirement plans or policies in place. To complicate the issue, legal firms face unusual circumstances not typically encountered by the average corporations. These circumstances include mandatory retirement age policies, retention of rainmakers, clients and institutional knowledge, partners who have invested life savings and a life time as firm founders. Smaller firms with ten or fewer attorneys can be especially hard hit by capital payouts for unfunded retirement obligations. Law firms can mitigate potential talent shortages, lateral loses or even competitive poaching by rethinking and, in some instances, redesigning retirement policies. We believe the findings in our 2010 study will be helpful to you and your firm by better positioning partners to accumulate and fund retirement wealth. I invite you to review the 2010 results of RCG|Benefits Group’s Retirement Planning for Law Partners – A Study on Trends and Tactics because a comprehensive retirement benefits strategy has never been more important or challenging. Sincerely,
William L. MacDonald Chairman, President, & CEO 1. Law Librarian Blog; http://lawprofessors.typepad.com/law
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B a c k gr o u n d
and
Methodology
The forward progress of successful law firms is driven, in large part, by the productivity of highly compensated partners. Competition for this talent is fierce. For this reason, expert retirement planning is a prominent strategy to 1) attract desired partners; 2) retain partners’ capital contributions; and 3) reward exceptional performance. A dearth of information exists on retirement planning within law firms. In an effort to elevate the practice within the legal community, RCG|Benefits Group undertook a nationwide study to learn more and, in the process, become more responsive to the needs of partners.
Study Objective RCG|Benefits Group’s Retirement Planning for Law Partners – A Study on Trends and Tactics was designed to draw a representative sampling of leading law firms and determine which retirement programs are currently in place and if these plans meet partner goals to accumulate sufficient retirement assets. With this first effort, we sought to identify issues facing individual partners in retirement planning, and what assistance, if any, firms provide their partners in the course of retirement planning. We also suggest alternative solutions to assist partners in filling the retirement gap such as cash balance pension plans or the Professional Security PlanSM.
Study Methodology An eleven-question survey was distributed online to 500 leading law firms, of varying firm sizes, and from different regions of the country. The following map provides a pictorial breakdown of the geographic locations of the respondents.
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Regional Breakdown
4% 12%
42% 42%
Questions focused on the type of retirement plans used for partners and formulas applied to calculate benefits. Of the 500 firms, 9 percent responded with completed questionnaires; the data was analyzed by RCG staff and is reported on the following pages.
Number ofParticipating Lawyers Firm Employed by Size of Firm Size 1 - 49 2%
50 - 200 26% Over 500 42%
201 - 300 14% 301 - 500 16%
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S u mm a r y
of
Conclusions
100 percent of all firms surveyed offer a 401(k) Plan.
Largest percentage (29%) offer a 50 percent matching formula.
90 percent of firms offer a qualified defined contribution plan or profit sharing.
64 percent of firms do not offer a defined benefit plan; of those that do, 80 percent represent firms with 500 or more attorneys.
40 percent of firms offer defined benefit plan availability to partners only.
Only 26 percent offer a cash balance pension plan for partners; of those, 27 percent use a compensation-based formula.
69 percent of firms do not offer a nonqualified deferred compensation plan. Of the remaining 31 percent that do, 39 percent of the plans are funded or partially funded.
Only 19 percent of firms offer partners participation in alternative wealth accumulation or retirement plans.
93 percent of firms offer some type of life insurance.
Interestingly, more than half of all firms do not have a mandatory retirement age policy; of those that do, 43 percent state age 65; 28 percent state 66; and 29 percent state age 70.
100 percent of firms offer long-term disability insurance to partners.
Slightly more than one-third of firms offer an equity (partner’s interest) buy-out program.
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401(k) Plans
Summary
Data
of
Cash Balance
100% of firms offer 401(k) plans. 40% of those match contributions.
26.2% of firms offer Cash Balance Pension plans for partners.
401(k) Match Match Details 401(k) Details
Other, Percentage Based 23%
Other, Partners Only 6%
Safe Harbor 18% Lump Sum 6%
50% on the Dollar with Limit 29%
Dollar for Dollar with Limit 6%
Cash Balance Pension Formula Question 4: Pension Forumla
Not Provided 37%
Lump Sum Contribution 9%
Frozen 9%
25% on the Dollar with Limit 12%
Compensation Based: Points 27%
Compensation Based: Percentage 18%
Other Plans 19% of firms offer other plans for their partners. Other Plans include: Lifetime benefits, Payout upon retirement or death, Pension plans, Supplemental after-tax life insurance. 93% of firms offer Life Insurance. 100% of firms offer Long-Term Disability Insurance. 36% of firms offer an Equity Buy-Out Program.
Defined Benefit 35.7% of firms offer Defined Benefit plans. 27% of the Defined Benefit plans are frozen. 40% of firms only offer Defined Benefit plans to partners. TypesDefined of Defined Benefit Plans Benefit Plans by Type Defined Contribution Plan 6%
Cash Balance Plan 27%
Defined Benefit Plan 67%
Nonqualified Plans 31.0% of firms offer Nonqualified plans. 39% of the plans are funded, 8% of which are only partially funded. 15% of the plans are frozen.
Enable Mandatory Retirement Question 8: Mandatory Retirement Age for Partners
Question 5: NQDC Funded Nonqualified Plan Funded
65 43%
Yes 40%
Yes 31%
Partially 8%
Mandatory Retirement Age Question 8: Retirement Age
No 61%
Partial 7% No 53%
70 29%
66 28%
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The Widening Retirement Gap Due to Internal Revenue Service restrictions on qualified plans, firm partners do not have the freedom or flexibility to accumulate wealth as do executive clients at publicly traded companies. This disparity creates a sizeable retirement gap as illustrated in the bar chart below. If firm partners expect to reach a level of retirement security which supports current lifestyles, this gap must be filled.
80% 70%
$97,119
60% 50%
$223,530 $392,078 $46,103
$729,174
40% 30% 20%
$46,103 $46,103
$67,462 $67,462
10%
$67,462
$46,103 $67,462
0% $125,000 401(k) Benefit
$200,000
$300,000
Social Security
$500,000 Additional Income
Assumptions • Age 45; retirement age 65 • 401(k) starting balance $50,000; contributions to max under laws • Salary increases 4%; social security includes 3% annual cost of living adjustment • 7% investment return
The IRS limits contribution amounts to qualified plans such as 401(k) plans, and subjects them to coverage and discrimination testing, which may further limit both employee and employer plan contributions. Let’s review specific limitations to qualified plans for 2010:
401(k) Retirement Plans
$110,000 of wages earned in preceding year classifies employee as “highly compensated”
Discrimination testing may limit deferrals; that is, deferrals made by the highly compensated are limited by the amounts deferred by general employees
$16,500 maximum deferral ($22,000 if age 50 or older)
Company contributions limited to $49,000
$245,000 maximum eligible compensation limit
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Limitations also apply to other types of retirement plans: Defined Benefit Plans
$195,000 maximum benefit payout
$245,000 maximum eligible compensation limit
Individual Retirement Accounts
$5,000 maximum contribution ($6,000 if age 50 or older)
Employees with adjusted gross income greater than $105,000 (married) or $63,000 (single) cannot deduct contributions to an IRA account if participating in a qualified retirement plan (IRC Section 408)
With these limitations in mind, how do firm partners fill the retirement gap? 1.
Personal investment: Take your after-tax income and invest in your own strategy
2.
Participate in an employer-sponsored, pre-tax nonqualified deferred compensation plan
3.
Participate in the Professional Security PlanSM, an after-tax accumulation strategy
4.
Do nothing
Keys
to
R e t i r e m e n t S u cc e ss
The cornerstone of a partner’s retirement planning is the firm-sponsored benefits plan. One aspect of these plans is the deferred compensation arrangement, which enables partners to defer segments of their compensation program for retirement at a later date. The tax structures at most law firms – limited liability corporation or limited liability partnership – may render deferred compensation plans (DCPs) financially unattractive. Thus, one must look for alternatives.
Tax-Efficient Path Sound retirement preparation calls for a partner to first establish his or her after-tax retirement income goal, adjusted for inflation. Then, he needs to determine if his retirement assets are sufficient to meet this goal. If not on track, the partner’s next step is to find the tax-efficient path to retirement security. While a firm-sponsored program may be a smart initial solution, it is important not to overlook other strategies such as:
Traditional deferred compensation plans
Qualified cash balance pension plans
After-tax strategies like the Professional Security Plan
Life Insurance accumulation plans
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Explanation
of
Plan Types
We offer the following section to help you to better understand the various types of retirement plans used by law firms. It is by no means exhaustive; however, this section will lay the groundwork for your decision making process.
Cash Balance Pension Plans Cash Balance Plans are defined benefits plans that resemble defined contribution (DC) plans in how they deliver benefits by way of a running account balance, called the Hypothetical Account Balance (HAB). The HAB is comprised of two components: Cash Credits and Interest Credits. Cash Credits are annual amounts credited to your HAB (similar to profit-sharing contributions). Cash Credits can be defined as a percentage of pay, a flat-dollar amount, or a percentage of the maximum allowed by law. These amounts are added to the HAB as of the last day of the plan year. Interest Credits apply to the HAB annually, based on the plan’s provisions. Interest crediting must not exceed a “market rate of return.” Typically, plans are credited with interest based on a 30-year treasury rate from the preceding year, or at a conservative, flat rate of no more than 5 percent. Both Cash Credits and Interest Credits are defined in the plan document. Thus, the participant’s benefit is defined, and is not allowed to fluctuate when a participant investment direction changes. This feature distinguishes the Cash Balance Plan from a DC plan. For example: A participant is in a Cash Balance Plan that provides an annual Cash Credit of $100,000, and annual Interest Credits of 5 percent. Year 1
HAB at Jan 1 0
Interest Credit 0
Cash Credit 100,000
HAB at Dec 31 100,000
Year 2
100,000
5,000
100,000
205,000
Year 3
205,000
10,250
100,000
315,250
To the extent actual investment return falls short of the Interest Credits, the plan sponsor must make up the difference over a period of time. Similarly, if asset performance exceeds the Interest Credits, the resulting surplus can be applied to future years, reducing the required contribution. Cash Balance Plans work particularly well for law firms. Because they are defined benefit plans, they provide deferral opportunities much higher than in any other qualified arrangement. In addition,
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Cash Credits can vary within the partnership group based on variables such as age, service, and ownership percentage, among others. Maximum allowable deferrals increase by age as one moves closer toward retirement. The following chart compares the estimated maximum deferrals:
16,500
401(k) + Profit Sharing (Full DC) 49,000
Cash Balance Maximum Deferral 60,000
Full DC + Cash Balance Max 109,000
40
16,500
49,000
78,000
127,000
45
16,500
49,000
100,000
149,000
50
22,000
54,500
128,000
182,500
55
22,000
54,500
165,000
219,500
60
22,000
54,500
212,000
266,500
65
22,000
54,500
220,000
274,500
Age
401(k) Only
35
Annual Testing Required If a Cash Balance Plan provides non-uniform benefits, it must be tested to ensure those benefits are not discriminatory in favor of highly compensated employees. For this purpose, non-uniform benefits are almost always combined with the firm’s existing DC plan. Non-discriminatory tests involve complex calculations under Section 410(b) and 401(a)(4) of the Internal Revenue Code. In addition, there are several other tests which must be performed annually. The following two tests are noteworthy: Minimum Participation under IRC Section 401(a)(26) Under this test, the plan must benefit a certain number of participants at a meaningful level. Smaller law firms must exercise caution to ensure the plan benefits are at least the lesser of 50 participants or 40 percent of eligible employees. This particular test only applies to the Cash Balance Plan; it is not combined with the DC Plan, and the DC Plan is not subject to this test. Gateway Test To test the Cash Balance Plan (CBP) and DC plan in combination, both plans must provide a minimum level of benefits to nonhighly compensated employees. This level usually amounts to 5.0-7.5 percent. In plan designs which provide large Cash Credits to participants close to retirement age, it is typically 7.5 percent.
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Situation: ABC law firm employs 410 partners, 430 associates, and 900 support staff; it decides to adopt a Cash Balance Plan to reduce the tax burden on the partnership.The Cash Credits vary depending on individual age and service with the firm, and a small percentage of the owners opt out of the plan. Plan participants continue to receive the maximum profit-sharing allocation in the firm’s DC plan. Associates are not eligible for any benefits other than their own 401(k) deferrals. Support staff received 5 percent as a profit-sharing allocation before the CBP. Now they receive 7.5 percent allocations, but are not eligible for any CBP benefits. Before Cash Balance Plan
After Cash Balance Plan
Count
Total Pay
Profit Sharing
Profit Sharing
CBP
Total
Partners
410
$330M
$13.3M
$13.3M
$28.0M
$41.3M
Associates
430
80M
0.0M
0.0M
0.0M
0.0M
Staff
900
45M
2.3M
3.4M
0.0M
3.4M
Total
1,740
$455M
$15.6M
$16.7M
$28.0M
$44.7M
Impact: The partnership of ABC law firm was able to reduce its taxable income by $28M, while only increasing its staff benefits by $1.1M to satisfy the Gateway Test. Situation: XYZ law firm has 60 partners, 90 associates and 120 support staff, and is considering adopting a Cash Balance Plan to accelerate retirement savings for key individuals. Cash Credits are offered at two basic levels, based on ownership percentage. All partners continue to receive the maximum profit-sharing allocation in the firm’s DC plan. Associates are not eligible for any benefits other than their own 401(k) deferrals. Support staff were receiving 5 percent as a profit-sharing allocation before the CBP. Now they receive 7.5 percent allocations, but are not eligible for any CBP benefits. Before Cash Balance Plan
After Cash Balance Plan
Count
Total Pay
Profit Sharing
Profit Sharing
CBP
Total
Partners
60
$40M
$2.0
$2.0M
$3.0M
$5.0M
Associates
90
15M
0.0M
0.0M
0.0M
0.0M
Staff
120
6M
0.3M
0.5M
0.0M
0.5M
Total
270
$61M
$2.3M
$2.5M
$3.0M
$5.5M
Impact: Under this arrangement, XYZ firm would have to pay an extra $200,000 in staff benefits in order to receive an extra $3M deduction – an easy sell. However, since there are only 60 partners, XYZ firm could face a problem with opt outs since the minimum participation test requires at least 50 participants to be covered at all times. Alternatively, XYZ firm could provide Cash Credits to a select group of associates or staff to ensure compliance with this test. Note: Information on cash balance plans supplied by Clarity in Numbers, LLC.
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Nonqualified Deferred Compensation Plans A nonqualified deferred compensation (NQDC) plan is an agreement entered into by a partner with his or her firm to tax defer compensation to a future date. The amounts are held by the firm (deferred) while the partner is actively employed, and paid out to the partner upon separation from service, disability or death. The partner does not pay income tax on those deferred amounts until the amounts are actually paid to him or her. Compared to qualified retirement plans, NQDC plans offer added flexibility, despite governance by IRC Section 409A. For the firm, these arrangements are “unfunded” obligations and the amounts deferred plus earnings are subject to the claims of the firm’s creditors. With unfunded deferred compensation plans, the firm may purchase assets like life insurance or mutual funds to help satisfy its obligations under the plan, but the nonqualified plan is not funded for ERISA purposes. If the plan is designed properly, compensation will not be included in the partner’s income until paid under the terms of the plan. The firm does not earn a compensation tax deduction until the benefits are paid, a fact that makes these arrangements unattractive for law firms, which are typically structured as Limited Liability Corporations or Limited Liability Partnerships.
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Professional Security PlanSM (PSP) Alternative The PSP is a firm-sponsored plan, controlled by the participant. What sets the PSP apart from nonqualified pension or retirement plans is the way investment gains are taxed. Contributions are made with after-tax dollars, but all earnings accumulate, tax-deferred, on the pre-tax amount (if loan feature is elected, discussed on the following page)1. Structured properly, distributions from the PSP are not subject to current taxation. What’s more, it also includes a non-taxable life insurance benefit. The PSP achieves its tax-advantaged status because it is powered by a variable universal life (VUL) insurance policy designed to provide high early-cash value relative to the premiums paid, carries no surrender charges and offers an innovative loan feature. The flexibility in product structure combined with access to a carefully selected group of fund managers offers the potential for strong long-term growth and performance2. The policy offers life insurance protection with access to more than 60 investment alternatives called “subaccounts� from fund managers such as Fidelity, Franklin Templeton, American Funds, and others. Please note, the PSP is not a qualified retirement plan like a Roth IRA or a 401(k) Roth and is not a nonqualified pension or deferred compensation plan. It is a strategy for putting after-tax dollars, and optional pre-tax dollars, into a variable universal life policy where earnings are tax deferred. And, if properly structured, distributions can be non-taxable.
1. Optional feature. Contributions refer to premiums paid into a variable life insurance product. 2. Depending upon the performance of the underlying investment options, the cash value available for loans and surrenders in a variable universal life insurance contract may be worth more or less than the original amount invested in the contract. VUL products are long-term life insurance products subject to investment risk. If the policy is classified as a Modified Endowment Contract under IRS rules, distributions are generally subject to income taxes and a 10% federal tax penalty
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Tax Restoration Concept Assume you have $50,000 pre-tax to contribute to the Professional Security Plan. After paying all the applicable taxes there is approximately $30,000 to invest after-tax, assuming a 40% tax rate. However, due to the unique structure of the Professional Security Plan, the amount that is invested can become $50,000 again. When the after-tax $30,000 premium is paid into the policy, the insurance carrier or other lenders can “loan” your account the amount paid in taxes, $20,000 in this example, so you have the entire $50,000 at work for you. The impact of taxes has been deferred.
Pre-tax Compensation
Taxes on Compensation*
Loan from Insurance Company**
$20,000
$20,000
Total Premium Paid
$50,000
$50,000 $30,000
$30,000
Net After-Tax
Premium to Insurance Policy
* Assumed 40% tax rate. ** Loan and source of loan is optional. If chosen, policy loan is non-recourse.
If using the ALR, this $20,000 is a non-recourse “policy loan.” The loaned amounts will not show up on your credit report or affect your debt/equity ratio. There is also no required repayment on the policy loan except through policy proceeds at surrender or death, and there is no pre-payment penalty. The policy loan’s interest rate or carrying charge (2.01% for September 2010) is the 90-day LIBOR rate plus 1.5% capped by the Moody’s Corporate Bond Rate.
Why Life Insurance? The Professional Security Plan uses a variable universal life insurance policy (VUL) to provide participants with tax advantages. There is a big difference between the VUL policy used with the PSP compared to what your financial planner may recommend; we’ll call that “Retail.” As an institutionally priced contract, the Professional Security Plan is generally not available to individuals and the charges are designed for employer-sponsored programs. In addition to enabling you accumulate retirement assets efficiently:
Assets accumulate on a tax-deferred basis
If properly structured, distributions are non-taxable
Survivor benefits are income tax free
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About RCG RCG|Benefits Group collaborates with Fortune 1000 corporations, leading non-profits and the highly compensated on best practices for executive compensation and benefits, and specializes in processdriven retirement consulting and the development of executive compensation and benefits programs.
“ To discover new and better ways to do things, you must
think differently. Be willing to risk and explore. Break open every possible box where answers and solutions lie in wait,
”
explains Bill MacDonald, Chairman, President and Chief Executive Office, RCG William L. MacDonald founded RCG in 2003 with one goal in mind: Develop an equitable, systematic process for organizations to attract and retain key talent and enable those executives to reach critical retirement goals. A pioneer in and major contributor to the executive compensation and nonqualified benefits field, Mr. MacDonald’s industry roots stretch back to 1978 with the launch of Compensation Resources Group, which grew to market leadership in nonqualified executive benefits, and was acquired by a NYSE consulting firm in 2000. Through his collaborative process on client accounts, his team developed many firsts in the business:
First to establish the fiduciary services concept, used by leading trust companies
First “haircut” provision for any time distributions (later altered by IRS §409A)
First to develop Secured Trust for bankruptcy protection in public companies; prevailed in court
First web-enabled platform for NQDC plan administration and custom client reporting
RCG is one of a handful of national firms offering the caliber of senior-level experience and resources to heavy lift companies through today’s labyrinth of legislation, regulation and market confusion.
RCG
Benefits Group
Solutions others overlook. Results others miss. © 2010 RCG|Executive Benefits & Compensation Group For additional copies, please contact RCG at (858) 677-5900 or email request to info@retirementcapital.com
RCG
Benefits Group
RCG |B e n e f i t s G r o u p 12340 El Camino Real, Suite 400 San Diego, CA 92130 Tel: (858) 677.5900 | Fax: (858) 677.5915 http://www.retirementcapital.com
Not an offer to sell. Variable Universal Life Insurance is available by prospectus only Securities are offered by Retirement Capital Group Securities, Member FINRA / SiPC. Retirement Capital Group Securities, Inc. is a wholly owned subsidiary of Retirement Capital Group, Inc. Investors should consider the investment objectives, risks and charges and expenses of the contract and underlying investment options, risks carefully before investing, The prospectus contains this and other information about the investment company and must precede or accompany this material. Please be sure to read it carefully. The opinions, estimates, charts and/or projections contained hereafter are as of the date of this presentation/material(s) and may be subject to change without notice. RCG endeavors to ensure that the contents have been compiled or derived from sources RCG believes to be reliable and contain information and opinions that RCG believes to be accurate and complete. However, RCG makes no representation or warranty, expressed or implied, in respect thereof, takes no responsibility for any errors and omissions contained therein and accepts no liability whatsoever for any loss arising from any use of, or reliance on, this presentation/material(s) or it contents. Information may be available to RCG or its affiliates that are not reflected in its presentation/material(s). Nothing contained in this presentation constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any investment product. Investing entails the risk of loss of principal and the investor alone assumes the sole responsibility of evaluating the merits and risks associated with investing or making any investment decisions. This report contains proprietary and confidential information belonging to RCG (www.retirementcapital.com). Acceptance of this report constitutes acknowledgement of the confidential nature of the information contained within. William L. MacDonald, Registered Representative - California Insurance License #0556980