How big should the buyout be?
By Marc Rosenberg
The Rosenberg Practice Management Library
Question from a reader: We didn’t contemplate an owner leaving before normal retirement age unless it was because of death or disability or we had to fire them. However, as we were discussing hypotheticals at a recent partner meeting, we came to the uncomfortable conclusion that, currently, there’s nothing to stop owners from accumulating large buyout balances and just walking in one day and offering up their resignation pursuant to our partner agreement, thus entitling them to receive substantial buyouts as long as they give us a one-year notice. Our vesting provision has a very limited penalty for early retirement: the buyout is reduced by 2 percent a year for every year before 60 they leave.
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No matter what, we need to modify our agreement so that if someone wants to leave early, they can do so, but they must know there will be a stiff penalty. We don’t want our partners to see their vested buyouts as large savings accounts that can be withdrawn at any time. Instead, we want them to see our buyout as a true retirement plan, one that is redeemed close to or at a normal retirement age. My current thinking is that we restrict it in a similar way to an employer-funded retirement plan. The first day you can withdraw is the day you reach 55½, subject to vesting provisions and stiff penalties for early withdrawal. We think there should be a minimum number of years as a partner in order to receive any buyout.
What do you think would be good practices? Say someone is 50, has been a partner for seven or eight years, and wants to leave to pursue a different career. Good for them, but we haven’t exactly planned for that as a firm, so the replacement is going to be expensive and challenging.
My Response
First, some overarching thoughts. Note that my responses only pertain to the goodwill buyout portion of retirement benefits, not the capital. Most firms do not place any restrictions on paying out capital, regardless of age at departure.
1. I will suggest solutions but, more importantly, your partners have to decide what they want and then come up with limitations that feel fair.
- Some firms, usually those with relatively young partners, find it important to allow for partners to retire at an early age, say in their late 40s or early 50s, to pursue other interests. “Younger” partners always think they will retire earlier than “older” partners, but later in life, it’s funny how almost all change their minds.
- Some firms want heavy penalties for partners leaving early because (a) they want their partners to stay with the firm until the age of at least 60, and/or (b) they don’t want to pay big buyouts to partners who leave way before normal retirement age.
Firms need to decide what they really want and design the variables to achieve their goals. These variable include defining:
- normal and early retirement ages
- number of years as an equity partner to fully vest
- penalties, if any, for withdrawing before a certain minimum retirement age
- minimum age, if any, to receive any buyout, regardless of the number of years as a partner
2. You say your buyout plan provides for an owner leaving due to death, disability or termination. It should also provide for withdrawal, which is the case you are addressing.
3. For many firms, the worst part of a partner retiring prematurely is not the financial impact of paying a large buyout; it’s the loss of expertise, value and time of the departing partner. This expertise could be technical (audit or tax), rainmaking, or management (loss of a great managing partner and no other partner remotely has the skills to replace the person) — or simply, the loss of client service hours before anticipated.
4. Partners should not see their buyout as a savings plan to be cashed out at any time with little or no penalty.
My observations and suggestions on your specific case:
1. The penalty for early retirement seems low at 2 percent a year. Many firms provide for 5 percent a year.
2. Some firms require a partner to reach 65 or so, to reach 100 percent buyout. Most firms, though, opt for 60 instead of 65. It can be unattractive to newer partners to know they have to stay in place until 65 to get their full buyout.
3. Vesting should be at least 15 if not 20 years. This way, the buyout accumulates at a slower rate. Note, this is years as an equity partner, not years with the firm.
4. You gave an example of a partner at age 50 withdrawing who has been a partner for eight years. Let’s see how the early withdrawal penalty might work if you chose the following variables:
- 20-year vesting or 5 percent per year
- For every year the partner withdraws before a minimum full-retirement age, say 60 or 65, the buyout is reduced 5 percent a year.
For example, using your assumptions:
- The partner begins 40 percent vested (5 percent per year vesting x 8 years as a partner).
- Let’s also assume the retirement benefit is 3x annual compensation.
- Assume comp to be used in this formula is $300,000 (*).
- 3x comp model results in a $900,000 potential retirement benefit.
- If 65 is the full retirement age, the partner departing at 50 results in a 75 percent reduction of vested benefits (15 years before age 65 x 5% reduction per year = 75% reduction), leaving 25 percent of vested benefits retained.
- 40% regular vesting x 25 percent amount retained after early retirement penalty = 10 percent of accumulated retirement balance due to withdrawing partner
- $900,000 x 10 percent = $90,000 due
- If 60 is the full retirement age, the partner’s departure at 50 results in 50 percent reduction of vested benefits (10 years before age 60 x 5% reduction per year = 50% reduction).
- 40 percent x 50 percent = 20 percent of accumulated retirement balance due to withdrawing partner
- $90,000 x 20 percent = $180,000 due
(*) There are other factors that affect a true multiple-of-comp calculation, such as three highest of the last five years. For the sake of keeping this example simple, we’re assuming that calculation results in an average compensation figure of $300,000.
Most firms would find these provisions sufficient to achieve a common ground: they enable a partner to leave young enough to pursue other interests while, at the same time, avoiding the unintended consequence of encouraging a partner to retire too early to “redeem” a large, accumulated buyout.
Again, I emphasize the importance of your partners deciding what they want and then selecting variables that achieve those goals.
