What Are the Biggest Challenges When Changing From a Comp Formula to a Comp Committee?

Common choices are not always the best choices. Eating unhealthy food. Electing political candidates who are the most popular but not the best qualified. Doing work for clients who are unwilling or unable to pay your bills.

Another example is the common decision by multi-partner firms – usually firms under $30M – to use that train wreck of a compensation system called a formula to allocate partner income. The reasons for using a formula, though well chronicled, are deeply flawed:

• Firms make money when partners are highly productive, so the income allocation system should encourage and reward those who amass a large client base and work a high number of billable hours.
• Accountants speak the language of numbers and so are naturally attracted to using a formula to compensate partners. At any time during the year, it’s easy to compute what your income will be.
• Formulas are objective. No disagreements. No second-guessing. Partners don’t need to trust any person or group to decide their pay.

When firms move away from a partner compensation formula, they usually select the Cadillac of all partner comp systems for multi-partner firms: the compensation committee (CC).

Based on the most recent Rosenberg MAP Survey:

• For firms with 9+ partners, 68% use a CC; 15%, use a formula.
• For firms with 5–7 partners, 33% use a CC; 26%, use a formula.

The messages from these stats are: (a) the CC system is the most commonly used system for multi-partner firms; and (b) despite the CC system being the most common, still a decent minority of firms use formulas.

Why is the comp committee system the Cadillac system?

1. The comp committee embraces the concept that a firm’s success depends on both production and intangible performance attributes such as management, leadership, mentoring staff and teamwork. Formulas aren’t well suited to recognizing intangibles. Comp committees give firms the freedom and flexibility to balance production and intangibles.
2. Formulas are hugely flawed because they encourage “me” behavior instead of the one-firm concept. To put it bluntly, partners are tempted to “game” the system.
3. There is another subjective system that firms use less frequently: the managing-partner-decides system. But many firms find this system unacceptable or unworkable because (a) there are too many partners for the MP to evaluate, (b) the MP isn’t comfortable being solely responsible for setting the income of all the partners and (c) the partners aren’t comfortable trusting one person to decide their compensation fate.

CPA Partner Compensation: The Art and the 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 ► trends and controversies and ►overall best practices.

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For firms converting to the Compensation Committee, these challenges must be addressed:

1. Will the CC have a mandate to freely use their professional judgment along with data to determine the compensation for the partners? Or will the CC be restricted to specific guidelines or parameters set by the partner group?
2. Do the partners recognize that intangible performance factors need to be compensated and that the lack of intangibles are one of the biggest flaws in formulas?
   • What will the balance be between production and intangibles?
   • Does the CC know how to measure intangible performance?
   • To the extent that there have been no performance evaluations of partners, is the CC prepared to introduce such tools as upward evaluations by the staff of the partners, self-evaluations by each partner and goal setting?
3. How will the MP be compensated, and who determines this?
   Will the partners trust a panel of judges? (If the people being judged don’t trust the judges, the system won’t work. Period.)
4. Does the CC understand that communication with the partners on how their compensation was determined is the key to the success of the CC concept? And that lack of communication will doom the CC to failure? Will the communication of comp information to each partner be done by management, or will the CC be a part of the delivery process?
5. Do the partners understand that, if they serve on the CC, they will likely be required to discuss difficult and sensitive performance issues with some of the partners? Do they have the courage to do this?
6. Will the CC be comfortable not having a nice, neat formula that makes their decisions “easy” and that, instead, they will have to make subjective judgments when putting an income number next to each partner’s name?
7. Is the firm prepared to deal with the extremely likely scenario that under the formula some partners were overpaid and some underpaid? And that by implementing a CC, changes to some partners’ income will occur? How will they deal with this? Will there be a two- or three-year phase-in plan to fully implement the changes?
8. Will the system be open or closed? If open, does the CC feel it can decide each partner’s income without feeling intimidated by the prospect of dealing with partners’ anger when they are disappointed with their income numbers? Put another way, is the CC prepared to deal with “problem partners”?
9. Can the firm articulate what the most important and least important partner performance attributes are and incorporate them into the income allocation process?
10. If the firm has partners who hoard clients and billable hours:
    • Will this continue to be allowed and handsomely compensated by the CC?
    • Will the CC be willing to counsel the hoarders, helping them understand that their hoarding habits will hurt their income?
11. Will there be a base and a bonus that are mutually exclusive, or will there be a draw which is an advance on one final income number?
12. Which of the following scenarios will describe the CC role?
    • Like a trial jury – empaneled for a few days or weeks and then disbanded
    • A permanent adjunct to the firm’s overall management, working with the MP throughout the year

The above challenges and decisions were observed in our work on partner compensation matters. In the past five years, we consulted with dozens of firms on the adoption or improvement of compensation committees. It’s not an easy process, but it can be done, and it is a benefit for firms which find their partners are not satisfied with the results of their formula system.