How Partner Compensation Systems Have Changed in 20 Years
The CPA profession has witnessed profound transformations in firm management. This blog aims to shed light on the sea of changes in partner income allocation methods, showcasing how these changes have influenced the overall dynamics of CPA firms. We will reflect on the changes over the past 20 years and, more importantly, delve into the implications.
First, some definitions
Objective vs. subjective comp systems. Objective systems provide little or no exercise of judgment in evaluating performance and setting compensation for each partner. With objective systems (formula, ownership percentage and pay equal), the facts are the facts. Formulas and allocation by ownership percentage are the two most common objective systems.
Subjective systems acknowledge other performance criteria besides partner production data and ownership percentage. These very important criteria include firm or department management, leadership, staff retention and development.
The most common subjective system, by far, is the compensation committee.
Performance-based vs. non-performance-based comp systems. Performance-based systems allocate income based on the relative performance of each partner. The most common performance-based systems are the comp committee and formulas. Non-performance-based systems allocate income without regard to each partner’s performance. The most common non-performance-based systems are paying based on ownership percentage and pay-equal. Spoiler alert: they aren’t very common anymore.
Compensation committee (CC). Income is allocated by a small number of credible partners, headed by the MP. The committee takes into account traditional production metrics as well as intangible factors. The main advantage of the CC is that a small group of partners use their unbiased and fair judgment of each partner’s relative performance to allocate income.
Formula. Income is allocated using an algebraic formula whose factors are primarily business origination, size of client base managed, billable hours and realization. Very few, if any, formulas take into account intangible factors and judgment.
Paper and pencil. Partners complete a ballot, allocating total partner income to each partner, including themselves. All ballots are averaged, thus producing the income amount for each partner. A dying breed.
Ownership percentage. Income is allocated on the basis of each partner’s ownership percentage. In practice, ownership percentage rarely has anything to do with performance.
Managing partner decides. Essentially, this is a one-person compensation committee.
Pay all partners equally. Firms using this system reason that all partners work hard and contribute in their own ways, and thus should be paid equally to avoid arguments and get the partners to focus on performance of the firm, avoiding unhealthy competition.
All partners decide. Partners meet in a room, the door is locked, and no one can leave until the group has somehow decided how much each partner should be paid. Essentially, this is a comp committee consisting of all partners.
For a much more detailed explanation of these compensation systems, please refer to our book on partner compensation.
CPA Partner Compensation: The Art and Science explains: Partner comp 101 • the 12 systems used by all firms • how to design your firm’s system • open vs. closed systems • the role of “book of business” • differences between large and small firms’ systems • the MP’s compensation • operating a compensation committee • linking partner compensation with strategic planning • data used to evaluate partner performance • compensation nuances • trends and controversies • case studies • overall best practices.
Changes in firms’ usage of the 7 comp systems over the past 20 years
Over the past 20 years, firms’ philosophy on allocating partner income has changed significantly. These changes include the following:
- CPA firms have come to understand that to be truly successful, there needs to be a direct link between partner performance and partner comp; i.e. performance-based systems. Action taken by firms: Firms are paying more attention to partner accountability and partner evaluation. No more free rides for underperforming partners who happen to have a high ownership percentage.
- Comp committees have become the system of choice among firms large enough to have such a group. Firms now realize that (a) the allocation of income should not be restricted to rigid formulas that fail to recognize subjective factors; and (b) for the income allocation process to work best, the subjective evaluation by highly credible partners is the key to a fair income allocation. Action taken by firms: Firms have changed their performance expectations of partners from 100% production to recognizing the critical importance of intangibles. This has led more firms to implement goal-setting programs.
- Formulas, the granddaddy of ancient comp systems, are far less common than 20 years ago because firms see that they are deeply flawed. Firms understand that they need their partners to perform well in production as well as in subjective or intangible areas. Also, many formulas are convoluted and overly complex. Einstein said, “If the formula is not beautiful, it cannot be right.” Action taken by firms #1: Partner who excel in production no longer get an automatic waiver on shirking the intangibles. Action taken by firms #2: Firms are no longer stubbornly clinging to their formulas because “that’s the way we’ve always done it.” Firms have made a mass exit away from strict formulas towards the more effective compensation committee system.
- Firms have concluded over the past 20 years that performance-based systems are way more effective than non-performance-based systems. Action taken by firms: The near-demise of once-common systems such as pay on ownership percentage and pay equal.
A note about small firms
The most difficult income allocations are between 2–3 partners. Firms of this size are too small to have a separate “committee” allocating comp for themselves. In the end, it best serves small firms to agree on what is a fair allocation for each year’s income, even if it’s not exactly derived from the process or formula they designed at the outset of the year or in their initial partnership agreement.
For some 2-3 partner accounting firms, the equal-split or ownership percentage approach works well for a number of years, especially in the case of a couple of founders who know each other well and agree that each contributes similar value, even if in different ways. However, at some point, one partner’s contribution often notably outweighs another’s, and not necessarily because one partner is doing anything wrong. In these cases, it’s important to revisit how income should be allocated.
How has your firm’s income allocation changed over the years? Have you seen benefits from using an updated approach to partner compensation?
No one partner compensation system applies to all firms. Both subjective judgment and quantifiable methods and tactics must be employed to result in an outcome that satisfies the partners and is perceived as fair. Tailor your partner comp system specifically for your firm: here's how.Learn More