By David Rhoads, Stuart Sadick and Alex Zabrosky
In healthy economic times, base compensation for partners in professional service firms creeps upward. This is because recruiting talent to build practices can require paying premiums to attract successful new partners and key players. Special salary adjustments and “one-off” deals are frequently used to keep key contributors. Overall salary structures can become bloated to preserve the relationship between base pay for senior, mid-tier and newly promoted partners and to keep everybody happy.
But when the economy turns weak, too much “fixed” (base) compensation can overwhelm the bottom line and make a difficult situation worse. When fixed pay is high, consultant and staff reductions must happen sooner and go deeper. And then there is little room to pay bonuses to reflect firm profitability or individual contribution to the firm, or to reinforce desired behaviors such as teamwork and strong client relationships. If client revenue dries up further, salaries are cut, and partners are asked to fund staff payroll. Lean times erode morale and undermine efforts to retain top performers when business eventually picks up: a lag effect.
Now is the time to evaluate partner compensation to ensure it is driving performance during and after the recovery. In some cases the action becomes simply to reverse steps taken over the past few years to survive. In others, more fundamental changes need to be installed to drive improved performance and to retain and reward top performers properly. However, decisions about compensation are complicated, fraught with emotion and rumor, and are seldom embraced by everyone. Senior partners approaching retirement may fear that any change will disrupt the status quo. Meanwhile, successful new partners may seek to capture a greater share of the compensation pool.
Significant cultural considerations attach to changing partner compensation. Are we a partnership or are we a collection of individual franchises? Will partners need to behave more like “hunters” or more like “farmers” to capitalize on changing client circumstances and beat out the competition? What behaviors do we value most and want to reward, and what behaviors do we want to discourage? How can we be fair to senior partners who built the firm while motivating newer partners who are responsible for the firm’s future? What role should annual cash incentives and long term equity play in rewarding performance? What are the implications of all this for our ability to recruit and retain top talent? And what are the costs of these changes not only in legal, tax and financial advisory fees, but also in management time and tranquility?
Three Approaches to Improving the Alignment between Business Needs and Partner Compensation:1) Shift from High Fixed Partner Salaries to Lower Draws.
Shifting from relatively high fixed partner salaries to lower draws can minimize fixed costs and maximize the size of the annual bonus pool. Partners receiving a draw have total monthly payments subtracted from annual bonuses earned when calculating annual cash bonuses. This means that two partners with different monthly draws but similar annual contribution to the firm would be paid very different cash bonuses but will have the same total cash compensation. In an extreme example, partners who fail to earn a bonus in excess of their annual draws are subject to a “capital charge” equal to this shortfall. Partner draws progress gradually over time and are much lower than fixed salaries.
At one major firm where annual cash compensation for top partners can exceed $1 million, annual draws range between $200,000 and $300,000. In contrast, some top-tier firms pay much higher base compensation and treat bonuses and fixed pay as independent. So a partner’s fixed pay is “safe” regardless of individual or firm performance. However, partners in those firms undergo rigorous performance evaluations every few years with a relatively high rate being asked to leave each year. This ensures that those who earn higher salaries are performing at a high enough level to support them.
The cultural implications of this shift can be significant. A draw-based system works best in entrepreneurial firms where each partner has significant autonomy. Client sales crediting and performance measures must be capable of relating results to individual contribution. A draw-based system is intended to attract and retain individuals who thrive where cash compensation can rise or fall dramatically year-to-year based on individual results. This approach also enables a firm to avoid the process of adjusting salaries annually to reflect competitive market practice, since fixed compensation plays a relatively small role in overall partner compensation.
A draw-based partner compensation system reinforces a strong performance-based culture and is highly motivational. Since the majority of a partner’s cash compensation is linked to annual performance, it ensures that pay and performance are aligned over a partner’s career.2) Create Partner Levels with Clear Performance Expectations
An alternative to a draw-based system is to tie relatively higher salaries to distinct partner levels. This requires (a) a clear definition of how partners contribute value to the firm, (b) a rigorous partner evaluation system and, (c) accepted performance standards. In addition to financial contribution, the evaluation system should assess the full range of things an organization actually values, such as firm leadership, client relationships, staff development, and thought leadership. The evaluation system and clear performance expectations align partner salaries with results and create transparency around career progression.
One top-tier U.S.-based global strategy firm reportedly has 15 levels of partners; six for junior partners and nine for senior partners. A major European-based firm has three partner levels with partner salaries determined by level. Intensive partner evaluations are completed every two to three years by a compensation committee to determine if a partner should progress to the next level, remain where they are, or exit the firm. Each partner is evaluated using the same factors, although the relative weight associated with each factor may vary based on partner role.
This has several important benefits, including aligning salaries with sustainable performance, reinforcing performance expectations and creating transparency around partner career progression (or exit). Some firms have extended the idea of transparent career levels and clear performance expectations to non-owner employees. While most people appreciate knowing where they stand and what they need to do to advance, top performers in particular value transparency regarding the path to partnership.3) Align Compensation with a Range of Career Options for Senior Partners
Many senior partners approaching retirement simply are not ready to retire and seek ways to extend their careers. Some cannot afford to retire completely while others want to continue working with their clients on a more limited basis. Meanwhile, some professional service firms prefer not to have certain senior partners leave in order to protect long-term client relationships, proprietary technical knowledge or business development capabilities. However, in some instances compensation levels for senior partners exceed their current productivity—many firms would be happy to retain them if their total compensation were lower.
Some firms align compensation with changing senior partner roles by modifying salary levels, changing the basis used to determine bonuses, or reducing required ownership. While some firms handle these changes on a case-by-case basis, best practice is to have a robust process in place so everyone is treated in a consistent manner. One major engineering consulting firm offers senior partners interested in semi-retirement various compensation options to accommodate their needs and those of the organization. These include part-time and project-based fixed compensation arrangements, on-going participation in the partner bonus (based on their individual roles) and the flexibility to sell shares back to the company over time (consistent with their desire to diversify their investment portfolio). However, these approaches only work if a firm has an objective way to measure and assess partner contribution to ensure that rewards are aligned with performance.
These structures help retain valuable senior partners and weed-out weaker senior partners while communicating to high performing junior partners that senior partners are treated fairly, but are not overpaid relative to their contribution.The Legal Overlay
Many of these approaches to improve the alignment between business needs and partner compensation need to take into account numerous legal considerations. These considerations vary depending on a firm’s size (small or large), ownership (public or private), governance (partnership or corporation) and its global breadth. When partnership agreements are involved, the process and the degree of difficulty associated with amending these arrangements varies widely. Existing executive employment agreement terms need to be considered as do “constructive termination,” age and other EEO-based issues. Proposed revisions will need to be vetted against the tax laws and the tax situations of the firm’s senior partners and junior partners.
These legal matters tend to be addressed as a design develops and the benefits of a revised system become clear to all parties involved. The guiding legal principle is that partners owe fiduciary duties of trust, good faith and fair dealing amongst themselves. Ultimately people will sign on to a new scheme that benefits the firm and aligns with their personal style and objectives.
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