Partner Comp: one-tier vs. two-tier system?

Some partner compensation systems provide for both a base and bonus that are mutually exclusive. At other firms partners receive a salary or draw during the year and a year-end distribution that adjusts the salary or draw to one final income number, based on each partner’s performance for the year.

What’s better, a one-tier or a two-tier compensation system?

Short answer – a two tier system is “better,” but to quote Jack Nicholson in A Few Good Men, “only if you can handle it.”

More informative response. How important is it to the firm to prevent partners from becoming complacent? From coasting? If it’s very important, then the two-tier system is the way to go. If not, then perhaps the one- tier system will work best.

If there is only one income tier, the system likely compensates partners on cumulative or historical production numbers, primarily book of business. In this scenario, once partners have built up their books they’re virtually guaranteed a high income level for many years. There is little incentive or encouragement for partners to continue working harder and smarter every year.

Firms that use a two-tier system often like compensation formulas, but acknowledge that formulas fail to recognize critical intangible performance attributes. So many firms compromise: apply a formula for the base and reserve 20-40% of total partner comp for a bonus to be allocated subjectively by a compensation committee or the managing partner. This way, the bonus essentially becomes a “what have you done for me lately” income tier, which discourages complacency and coasting.

Firms use a myriad of bonus systems, but the best take into account:

1. Achievement of written goals.
2. Intangible performance factors such as teamwork, loyalty, work ethic, firm management (not admin) and perhaps as important as any, helping staff learn and grow.
3. Hitting home runs.
4. What each partner did to help the firm have a “good year.”
5. MP’s judgement.

One big downside to a two-tiered system should never be underestimated: Does firm management have the desire, ability and sophistication to differentiate partners’ historical performance from their current year performance? Can they manage a proper partner goal-setting system? Many firms under $15M do not have the wherewithal to make this differentiation. These firms will struggle with a two-tier system.

Final observation: When the firm’s total partner income greatly exceeds budget or expectations the bonus pool becomes larger. But the reverse should not be true. In other words, if the firm’s partner income falls well below expectations, firms should resist the temptation to shrink the bonus pool. Instead, these firms should reduce partner bases during the year to preserve a substantial bonus pool at the end of the year.

An increasing number of firms now rely on committees to make the subjective determinations that will keep partners striving to hit home runs year after year. For a turn-by-turn roadmap, consult our monograph How to Operate a Compensation Committee.