I sat down with Richard P. Terhune, Jr., CLTC, LUTCF of New York Life to ask him the top 3 things that our clients, including attorneys, don’t realize they need in terms of agreements or policies. Many of these issues are applicable to all types of companies but I’ve focused on attorneys and law firms in particular.
- Retirement plan(s)
- Key person protection (in case of death or disability)
- Buy-sell agreement addressing seven different triggering events
1. Retirement plans
According to Richard, “One of the things that we hear from many of our attorney clients is that no matter how much money they make, they still have not put away enough money for retirement. When preparing for retirement, it’s difficult for the average person to envision how much money they actually will need in order to retire at the same standard of living.”
Several factors are driving up the amount needed:
- Prevailing interest rates are lower.
- Life expectancy is greater, meaning money must last longer.
- On average, less income is coming from other sources such as company provided pensions.
Today, a safe withdrawal rate – one that gives a reasonable certainty of having enough income even if the person lives well beyond age 90 – is not much above 3%. So an individual who retires at age 65 and desires a retirement income of $100,000 per year must accumulate over $3.3 million.
Income tax diversification is critical because increasing income tax rates will put downward pressure on standard of living. Translation – higher income tax rates mean having to accumulate more pretax money in order to generate the same standard of living. Having tax-free sources of income provides protection as well as flexibility. Planning for your retirement is something that everyone should do, no matter where you work, for instance, if you are a police officer you need to think about what to consider for NYPD retirement and every other police department retirement as well, it is vital this is discussed and sorted through.
In Richard’s experience, “Many professionals don’t know they have additional options for retirement plans beyond qualified plans like 401(k) or IRA’s. These other options – such as Section 162 plans, and split-dollar non-qualified deferred compensation – allow lawyers to pick and choose plan participants, or get a deduction for the firm, or avoid payouts being counted as current income, depending on their plan objectives.”
It’s important to remember that there are many choices when it comes to retirement plans and investments. Your advisor should walk you through options such as qualified options (401k, SIMPLE IRA, defined benefit pensions, etc.) versus non-qualified options (Section 162 plans and split-dollar non-qualified deferred compensation, etc.)
2. Key Person Protection
Terhune noted that time and again, “Many professionals fail to protect key employees in their practice because they don’t know how to value their contribution to the firm’s bottom line, or how to calculate the cost of replacing them.”
Key person protection:
- In a law firm individual attorneys, for the most part, generate their own income, so there is a tendency to believe that the firm doesn’t need life insurance to protect itself from the death of a key person. And yet, each of the attorneys are also contributing to paying the overhead of the firm which does not materially change at the death of one of the attorneys.
- Most law firms have “rainmakers” that often generate disproportionate share of the firm revenue. The death of a rainmaker would have a significant impact on the operating results of the firm.
Costs of losing a key person:
The total costs of losing and replacing a key person are often not accurately assessed. One reason is because these costs come in chunks over a long period of time and may not easily be summarized. The second reason is because many costs cannot be easily recognized in advance.
The cost of losing a key person – especially one who was a highly trusted and effective member of the team – can be significant. Here are some of the potential costs to consider:
- Distraction costs. There will be a gap in time that the practice will be without one of its leaders. In a law firm, one attorney will likely assume oversight during this interim period and coordinate the replacement search and conduct interviews. Typically this additional responsibility either adds to an already overloaded schedule or takes away from revenue-producing activities.
- Recruitment costs. This position may represent a specialty skill set that isn’t readily available therefore an outside professional will likely be required to assist in recruitment.
- Inefficiency costs. The practice will not run as smoothly with a key person missing. Time does equal money.
- Ramp-up costs. It will take months of training and reorientation before the practice is running normally, again.
- Fit. Incurring this expense does not guarantee that the new person will be the right fit so the process may have to be started again.
3. Buy-Sell Agreements
Richard’s last insight was how surprised he was that so many law firms “don’t have a buy-sell agreement, or that their agreement is outdated or unfunded; it reminds me of the old saying ‘the cobbler’s children have no shoes.’ It’s critical that the plan address the seven triggers of a buy-sell agreement: Death, Disability, Divorce, Termination of employment, Insolvency/bankruptcy, Retirement, Incompetency or Imprisonment. A properly drafted buy-sell agreement must also value the firm’s assets; it will either specify the value of the firms’ assets as of a certain date or the method of valuation for the assets. The agreement must also be funded properly so that in case of one of the triggering events occurs, the remaining partners have the funds to fulfill the terms of the agreement. “
In a buy-sell agreement, business owners agree to transfer their interests in the event of death retirement, disability or other designated events. Without such an arrangement, departure of a principal can result in economic and emotional uncertainty. For example, if an owner dies and leaves his interest to someone currently outside the business, a substantial question exists as to whether that individual has the skill, energy and experience to carry the necessary load. Even if co-owners have an informal buy-out understanding, the deceased’s family may not be willing to sell the business interest to remaining owners at a reasonable price. Or, an owner might simply leave, selling his interest to an outside buyer, who might disrupt operations by seeking more salary, higher dividends or other changes.
Whether you’re an attorney, partner or the head of a company, your attention your retirement plan, key person protection, and buy-sell agreements are crucial to the success and longevity of your firm. Despite our tendency to put off addressing difficult topics, these cannot be ignores. As they say, Carpe Diem –seize the day… and the opportunity to resolve these issues for yourself.