Attorneys are often unaware of and unprepared for the wealth planning opportunities unique to being a firm partner. The financial difference between making all of the right versus all of the wrong choices can exceed $3 million over the course of a legal career.
This is personal to me. I am a fee-only CERTIFIED FINANCIAL PLANNER™ married to a partner at a large, international law firm. Many of my clients are partners at elite law firms. Over the years, I have observed the common threads that drive wealth creation for law firm partners.
To demonstrate how this might affect your finances, let’s examine two case studies: Leslie, a new partner, and Sam, a 50-year-old senior partner.
1. The $1 Million Choice for New Partners: Cash Balance Pension Plan Participation
Many top firms offer a cash balance pension plan (CBPP), a special, additional tax-deferred retirement plan exclusively for partners.
Participation in a CBPP is an irrevocable election that drives mandatory contributions which can grow to over $100,000 annually as a partner approaches retirement. New partners, like Leslie, will have only four to eight weeks to make the election. At that same moment Leslie is considering whether to funnel an exponentially growing pile of money towards savings each year, she will be assessing a mountain of new expenses.
- $37,000 in mandatory profit-sharing contributions, ever year
- a partnership buy-in that can exceed $100,000
- capital contributions that can soak up 6% of your annual gross income
- mandatory life insurance
- additional disability insurance
- and a tripling of out-of-pocket health insurance premiums.
Don’t get me wrong, making partner is financially awesome. But you can see how in the blur of these moving parts, many new partners are unsure of how to proceed. While choosing not to participate could cost our new partner, Leslie, $1,000,000 in retirement savings, with the new expenses she’s facing, participation shouldn’t and can’t be an automatic “yes.” The truth is that not everyone should elect to participate. Depending on her personal circumstances, a new partner like Leslie could find themselves rich in savings but poor in her ability to live life, educate her children and pay off school debts.
There is a balance to strike when making this kind of decision and ideally, you should be working with an independent Certified Financial Planner and fiduciary who is familiar with these plans in the months leading up to your making partner. By planning in advance, you’ll be able to take a detailed look at your cash flow and consider the best options and trade-offs for your situation.
The Power of Tax Deferral
The chart depicts the annual taxes avoided and savings created for, our new partner, Leslie, by her participation in her firm’s cash balance pension plan (CBPP).
2. Avoiding an Overly Conservative Allocation: A $2+ Million Dollar Mistake
The cash balance pension plan, like its name suggests, is invested very, very conservatively and so is a partner’s capital account (firm equity). If this conservative allocation isn’t taken into account to have its effect offset by being less conservative in other investments, it could cost Leslie, our young partner, almost $2.3 million at her retirement. For Sam, who is already age 50, being too conservative can still cost over $1.5 million.
If, outside of these two conservative pools of money, Leslie invests 60% in stocks and 40% in bonds, the combined effect is to see her combined asset allocation (including the CBPP and firm equity) dropping as low as 30% stocks and 70% bonds (red line). At the other extreme, if the assets she directly controls (allocable assets) are invested 100% in stocks, that creates an overall allocation much closer to the hypothetical and intended 60% stocks and 40% bond mix (blue line).
3. Living More Fully Now
As a partner, you have visibility—in a way that is rare in the professional world— into how your income will grow over your career. The benefit of this is it can let you live your life more fully and more aligned with your values sooner than those whose income is less predictable.
In my experience, firms are very forthcoming with general expectations about future earnings. The earnings guidance might look something like the scatter-plot below where you can get a good sense for the low end to mid-range of how your earnings might play out over time.
With a conservative earnings path identified, a competent CFP® can create a lifetime cash flow model that looks something like this chart, which depicts the allocation of annual cash flow where one’s income is directed to taxes (grey), spending (blue) and savings (green) from age 35 through retirement at age 62.
Isolating just the savings in the chart below, three insights emerge:
- Upon making partner, firm-sponsored savings vehicles (partner equity, profit sharing, 401K, and cash balance pension contributions) soak up all available savings for 5 years.
- Partnership equity (which is similar to cash) and the cash balance Pension (as much as 90% bonds) dominate savings for an extended period of time.
- Career span savings are backloaded into the last 7-10 years of this career. That is both an opportunity (to live more fully in the present) and a risk (premature career end) that the client and their advisor must weigh and probably insure against.
Taking into account the high visibility of your earnings growth will enhance your ability to live life as fully as is possible sooner than later.
4. Firm-Sponsored Private Investments: Icing on the Cake or Dangerous Territory?
Firms with a substantial tech and startup client base often provide opportunities to invest directly in firm clients, be they venture funds or companies. At many firms, the track record of these investments has been impressive.
However, a private investment is very different from investing in a portfolio of publicly traded stocks, bonds, and real estate. In the latter, a bear market is more of an annoyance than an actual set back. The longer you hold a traditional portfolio, the narrower the range of expected outcomes and the more likely your result is to be positive. The same cannot be said for private investments.
Lightning strikes irregularly in private investing. Your gains may be concentrated in a few winners. As such, when making a private investment, you want to maximize diversification, spreading your dollars over as many opportunities and as many years as possible. You also want to set a maximum allocation to these riskier, more illiquid vehicles easing into the allocation over 7 or more years.
You have to be cognizant of the illiquidity of these investments. Funds can be tied up for a decade or longer and they increase the cost and complexity of your tax filings. Neither factor makes these investments impossible, but it is best to model out their impact to ensure you won’t find yourself in a cash crunch or tearing your hair out at tax time.
But Wait, There’s More (Complexity)!
The above are four large examples of how wealth planning for partners at top law firms is unique, however, there are many other eccentricities associated with the finances of a law partner:
- Your cash flow will be highly seasonal.
- Lines of credit may be necessary over short periods of time to manage estimated tax payments.
- Private banking relationships enabled by your firm can provide preferred access to credit.
- Mandatory retirement may come into play.
- Investing in individual equities may be prohibited or constrained.
It pays to work with an advisor who understands the finances of a law partner.
Ask your advisor about some of the concepts mentioned above to assess their expertise or reach out to schedule a consultation call to determine if it’s a fit to work together. Even if Abacus isn’t right for you, we’ll do our best to refer you to someone excellent.
For more information on how to manage your wealth as a law firm partner, check out these videos:
For associates about to make partner: The Choice
For existing partners: Perfecting Partnership
*All figures are adjusted for inflation and represent 2019 dollars.
BASIC ASSUMPTIONS
Inflation: 3%
ANNUAL INCOME ASSUMPTIONS
Attorney (increases at the rate of inflation)
2019: $ 400,000
2020-21: $ 455,000
2022-23: $ 640,000
2024-25: $ 705,000
2026-27: $ 775,000
2028-30: $ 850,000
2031-33: $ 980,000
2034-36: $1,125,000
2037-39: $1,300,000
2040-42: $1,700,000
Spouse (increases at the rate of inflation)
2019-42: $ 30,000
ANNUAL SAVINGS ASSUMPTIONS
Profit Sharing Plan / 401K
Employer Contribution (increases at the rate of inflation)
2020-42: $37,000
Employee Contribution (increases at the rate of inflation)
2020-42: Maximum Allowed
Scenarios discussed look at two allocations in these accounts.
100% equity – 0% fixed income portfolio with a net after fee expected annual rate of return of 8.95% with an expected standard deviation of 15.43%.
-or-
60% Equity – 40% fixed income portfolio with a net after fee expected annual rate of return of 6.39% with an expected standard deviation of 9.38%.
Cash Balance Pension Plan (increases annually at the rate shown below)
2020-21: $20,000 (+3.00% annually)
2022-23: $39,500 (+3.00% annually)
2024-27: $66,000 (+4.65% annually)
2028-33: $82,000 (+5.60% annually)
2034-42: $80,000 (+7.00% annually)
All scenarios with a cash balance pension plan assume the balance is invested 10% equity – 90% fixed income portfolio with a net after fee expected annual rate of return of 3.19% with an expected standard deviation of 3.02%.
Partnership Equity
Assumes 6% of the attorney’s gross earnings are contributed to partnership equity from 2020-2042.
All scenarios with a cash balance pension plan assume the balance is invested 0% equity – 100% fixed income portfolio with a net after fee expected annual rate of return of 6.00% which is distributed annually as income with an expected standard deviation of 0.00%
Partnership Equity is assumed to be disbursed in 2042.
Individual Retirement Accounts
Cash balance pension plan, profit sharing and 401K savings are assumed to roll over to an IRA at retirement. The IRA is assumed to be invested in a 60% Equity – 40% fixed income portfolio with a net after fee expected annual rate of return of 6.39% with an expected standard deviation of 9.38%.
Taxable Accounts
All excess savings is invested in a taxable account. Scenarios discussed look at two allocations in these accounts. At retirement in 2042, all balances are assumed to be in the 60/40 portfolio.
100% equity – 0% fixed income portfolio with a net after fee expected annual rate of return of 8.95% with an expected standard deviation of 15.43%.
-or-
60% Equity – 40% fixed income portfolio with a net after fee expected annual rate of return of 6.39% with an expected standard deviation of 9.38%.
SPENDING ASSUMPTIONS
Two Kids both incurring the following education expenses:
Private K-8: $35,000/yr. (+5% annually)
Private High School: $45,000/yr. (+5% annually)
College (4 years): $75,000/yr. (+5% annually)
Discretionary Spending (adjusted annually for inflation):
2019-26: $14,000/mo.
2027-30: $15,000/mo.
2031-42: $20,000/mo.
2038-42: $30,000/mo.
2042+: $26,000/mo.
Housing
Sell $1,200,000 home ($1,000,000 cost basis) on 12/31/2020. Property taxes on current home run $11,000 annually. Mortgage payments run $3,617 monthly.
Buy $2,250,000 home on 12/31/2000. Property taxes to run $25,000 annually. Mortgage payments assumed to be $9,663 monthly.
CHART DESCRIPTIONS
Chart #1 compares two scenarios, one with and one without a cash balance pension plan where nothing else changes. The orange line depicts the increase to annual savings made possible by the use of the cash balance pension plan. The blue line depicts the taxes avoided by participating in the cash balance pension plan,
Chart #2 compares two scenarios. Each line shows the equity versus fixed income allocation across all investable assets. The yellow line assumes that all assets outside of the cash balance pension plan and partnership equity are invested in a portfolio of 60% equities and 40% fixed income. The green line assumes that those funds are invested 100% in equities.
Chart #3 compares the total of investable assets at retirement in 2042 where the assets were invested consistent with the yellow line versus the green line in Chart #2.
Chart #4 depicts how partnership income increases over time within a range. This is entirely for illustrative purposes.
Charts #5 and #6 depict the annual allocation of spending across taxes, spending and saving from 2019 to 2042.
