Retirement Payment Circuit Breakers You Need

We always tell people that we’re one firm smarter than the last firm we worked with. As consultants, we learn from our clients and our 25 years of CPA firm client experiences are shared with every firm we consult with. The title of this blog is one of those learning moments.

A circuit breaker is an automatic device for stopping the flow of current in an electric circuit as a safety measure. A client of ours once used the term “circuit breaker” to describe various provisions in a partner retirement/buyout agreement that prevent partner buyout payments from being a cash flow burden on the firm. This term is a brilliant analogy and we’re grateful our client was amenable to us to use it in our work.

Six “circuit breakers” to ensure that your partner buyout or deferred compensation plan never becomes a cash flow burden:

1. The math must work. When partners retire, the remaining partners should earn more than they did prior to the retirement or no worse than the same. The main way they do this is by no longer having to compensate the departing partner. It works like this:

+    The firm “saves” the compensation of the departing partner.
–     The firm pays the goodwill buyout.
–     The firm pays the compensation of a newly hired person to replace the time worked by the departing partner.

         =    NET TOTAL MUST BE POSITIVE.

If the math doesn’t work, the buyout plan is usually untenable. Most accounting firm partners will not be willing to pay a partner buyout if it causes their income to go down.

One of the nuances of this circuit breaker is this: If a firm has a “rich” goodwill buyout valuation (say 1 x fees) but has low profitability, and hence the compensation of the retiring partner is low, then it will be more difficult to make the math work because the money saved by no longer compensating the partner may not cover the buyout payments.

2. Specify an annual limit on all buyout payments in a given year. This primarily addresses scenarios in which multiple partners receive buyout payments in the same year, resulting in an unaffordable cash flow burden. If the limit is invoked, no one loses benefits. Instead, the buyout gets paid over a longer payout term. A common provision for the limit is 5-10% of annual revenue.

We see this circuit breaker being triggered when there is a high concentration of ages or retirement dates of partners. E.g. a firm with partners aged 42, 53, 67, 69, 71 are going to need it when the three older partners retire.

Our book, CPA Firm Partner Retirement / Buyout Plans is a must-read for firms that either need to revise and update their existing plans or need to write a new agreement. The book addresses ► what CPA firms are worth ► what partners must do to get their buyout money ► how to value a firm’s goodwill ► the acid test of a well-conceived retirement plan ► 6 methods of determining an individual partner’s buyout ► vesting ► notice and client transition requirements ► mandatory retirement ► non-compete and non-solicitation covenants ► how to prevent your plan from becoming a Ponzi scheme and other issues.

Purchase your copy today!

3. Reduce the buyout if clients leave. The entire basis for paying a buyout is the firm being able to retain the clients of the departed partner. Larger and more mature firms don’t worry about client loss as much because they operate on the one-firm concept and thus, the likelihood of losing a retiree’s clients are minimal because other key firm members have relationships with the clients.

Smaller firms and less mature firms often operate on an “eat what you kill” basis and as such, there is a much higher risk of client loss when a partner retires. As a result, smaller firms insist on linking the buyout payments to client retention. For example, if the firm loses 20% of the clients of a retired partner, then his/her buyout payments are reduced by 20%, or something along these lines.

4. Reduce the buyout if a departing partner fails to comply with the firm’s notice and client transition policies. Non-compliance with these provisions increases the risk that the firm will lose the retiree’s clients upon his/her departure. In addition, non-compliance will place a substantial burden on the remaining partners to assume immediate responsibility for managing these clients at a time when they are already too busy with their own clients.

Notice periods are trending longer, we’re seeing firms require 2 – 3 years now to give ample time to transition client responsibilities.

5. Reduce the buyout if specialty services walk away when the service provider leaves the firm. Examples of specialties are business valuations and M&A. Remember, the primary justification for paying a buyout is client retention. The only way to retain specialty services is to institutionalize them – more than one person has the specialty skills and the ability to bring in new business in the specialty area.

At a MAP conference, this subject was discussed and one highly credible MP said: “If you are the only person in your firm that provides a specialty service, shame on you.”

6. Reduce the buyout if an extremely large client leaves when someone retires. Again, the justification for paying a buyout is client retention. For example, let’s say a firm has one client representing perhaps 10-20% or more of the firm’s total revenue. Many firms have a provision that reduces the buyout if the large client leaves, even if the retiring partner did his/her best to transition the client.

The moral of the story:

Hire an expert electrician to install state-of-the-art circuit breakers.