Where's the equity
By Kevin Wood
Equity partners may be seeing big rewards while earning for the firm, but what about on retirement? Kevin Wood explains what equity partners should consider when investing capital in the firm
Equity partnership is the ambition of most law school graduates. It’s a sign that all your hard work and study has paid off and your contribution to your firm’s success is being recognised with a share of the profits.
Indeed, your future earnings as an equity partner in a law firm are likely to be well above those of many graduates in other professions. Keep up your earning levels, and it would be only natural to assume you’re made for life.
Unfortunately, this is an assumption often misplaced, but there are ways in which you can ensure your financial future remains secure beyond your working years.
The real cost of equity
An equity partnership means you probably borrowing a significant sum (typically at least £50,000 and potentially more than £100,000) to buy into the firm in return for an annual share of the profits.
Alternatively, you may accept a reduced share of the profits for the initial period in lieu of that lump sum contribution, though this is not such a common route to equity partnership.
As a new equity partner, you may also be expected to contribute further sums every year for 10 years or more until your investment reaches the level required.
Many firms offer incoming equity partners interest free loans to finance a partnership. These loans are also typically repayment free in the first year, but it remains a financial obligation you need to factor into your personal wealth management if you are considering accepting an offer of equity partnership.
Equity partners will see their financial contribution to the firm as an investment in their future which, in a career sense, it is: an equity partnership could lead to a significant increase in your income.
But it is not an investment in the strict financial sense, that is to say, an allocation of funds towards an asset which will increase in value over time; and return more than the original sum invested.
There is also the usual caveat that investments can go down as well as up. But provided the cash is sensibly invested over the long term, with a view to capturing market returns and reducing costs, it has historically been the case that your investment will not only have been protected – but will have increased in value.
Your equity contribution to the firm is actually an investment in your future earning potential. But as you get older, your earning potential decreases – purely because you have fewer earning years ahead of you. This means the value of your future earnings also decreases (see fig 1).
Once you retire or otherwise leave the firm, the capital you have invested will not have grown a penny, regardless of the fact that your efforts at work, and those of your fellow partners, could have transformed the profitability of the business while you were with the firm.
Compare this to many of your university peers who may well have bought (or been remunerated with) shares in their own companies and can look forward to a nice little nest egg as a result when they retire.
That’s not to say becoming an equity partner is a bad financial decision – far from it. But at the same time, you may want to consider the wisdom in setting up an investment portfolio that will deliver the growth and future financial security you will need.
Prepare for pitfalls
While the financial rewards of partnership are usually considerable, it pays to be aware of the downsides so that you can effectively prepare for the risks.
Whether you are a full or fixed share equity partner, you are self-employed as a sole trader in the eyes of HMRC. Your income tax and national insurance (NI) is your own personal responsibility, so you need to take more of an interest in your tax affairs than you may otherwise have done.
That said, your firm will typically handle your tax returns and payments, but the monthly payments into your own bank account isn’t a salary as such, so tax and NI will not have been deducted at source.
However, in practice the firm will usually calculate your monthly drawings so that it can then pay your tax bill directly to HMRC at the end of the year for you – and pay you your share of the profits. But as far as the taxman is concerned, it’s up to you to make sure this is all done property and above board.
The payment of tax is your personal responsibility and HMRC will come after you and not your firm if it thinks there has been an error.
Pensions double whammy
Apart from these tax implications, self-employment means you probably won’t be part of a company pension plan, so you will miss out on any generous employer contributions. This means you will be responsible for establishing your own pension plan.
Once you’re a higher earner for tax purposes, you are limited to how much you can put into your pension. Those saving for a pension can put an annual maximum of £40,000 into their pension pot (excluding any carry forward allowances) and get tax relief on it. But if you earn more than £150,000, the £40,000 allowance is reduced by £1 for every £2 of income over this level.
This means, for example, if you earn £200,000 a year you can only put £15,000 into your pension without being penalised with an annual allowance tax charge. The tapering of the annual allowance reduces your £40,000 annual allowance by £25,000 – giving a £15,000 allowance to the partner.
The more you earn, the more you are penalised on your pension savings. Earn £210,000, and you can only contribute £10,000 – although the taper is collared at that point.
While £15,000 a year is a decent pension contribution for many people, for high earners – such as law firm equity partners – it is effectively capping the amount you can affordably contribute towards your retirement.
Plan for the future
Another downside to equity partnership is the lack of employment rights. If you fail to perform for whatever reason, your income could be reduced or, in serious cases, your partnership could even be revoked. If the firm goes bust, you lose both your income stream and your capital investment.
So if you were treating this as your pension pot, you will also have lost your retirement fund – and the closer to retirement you are, the more you have to lose. But enough with the gloom and doom.
None of these issues should amount to a good reason to turn down the offer of equity partnership, which carries with it professional prestige as well as personal financial gain.
This is because you’re buying into the profits of the business and benefiting from income the other partners are bringing in – as well as your own. It is, however, a wake-up call to potential partners who think owning an equity stake in their firm means they’re made for life.
The sooner you understand the issues and take control of your finances in your partnership career, the better.
Bear in mind there are plenty of other options for boosting personal wealth and securing your financial future. The right financial adviser with specialist knowledge and experience in advising clients in the legal sector can help you choose what’s best for your personal goals and circumstances.
Long working years
The trouble with a lucrative revenue stream vis that you tend to live up to it, so understandably you will want to continue the lifestyle you’re working hard to maintain. But if you’re not creating wealth separately from your earnings, you may find you can’t afford to retire as early as you’d like.
As one equity partner who had built a successful career over more than 25 years observed: “You see lawyers who are practising until they are 75 and you have to wonder. Is it true love for the law … or is it because they have to?” The answer is to manage your lifestyle expenses and turn a portion of your current substantial income into productive wealth – in other words, investments that will grow over time and generate income that’s separate from your earnings (see fig 2).
That way, you can carry on spending the money you are earning to meet the lifestyle you’re building, while at the same time your investments grow to create wealth to replace the income you are spending.
It’s not about IQ
Sounds simple, doesn’t it? And you’re a lawyer – an intelligent and confident individual, so it shouldn’t be too difficult. But effective investing isn’t about skill or intelligence, it’s all about the emotion.
As Warren Buffett, perhaps the world’s most successful investor, said: “Success in investing doesn’t correlate with IQ. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.”
Emotions are one of the biggest destroyers of wealth. You need to be able to fight the temptation to chase attractive but risky short-term gains at the expense of gradual wealth accumulation.
Unfortunately, this is something the financial media and investing commentators make it hard for even the most level-headed and resolute to do. Pages filled with the ‘latest sure thing’, ‘unbeatable returns’ and ‘sure fire winners’ make it difficult to resist a flutter.
Appoint a chief finance officer
You may well already have some investments – perhaps they’ve been recommended to you by a friend or colleague, or you read about them in the money pages of the Sunday papers and decided to join in. They may be good investments. Or not. But they’re unlikely to be part of a planned, goals-oriented financial strategy.
Having a highly experienced professional – call them your personal chief finance officer (CFO) if you will – to advise you according to your best financial and personal interests, will make it easier to define and plan for those goals. Your ideal CFO will be someone who takes a holistic approach to managing your wealth, will not personally benefit from those risky short-term gains and ensure your lifestyle doesn’t take a dip in retirement.
By paying a fixed annual fee (instead of a percentage of the value of your portfolio as many financial advisers do), you can be sure of your personal CFO’s independence and unbiased decision-making.
They will invest your money to ensure you achieve what’s most important to you. They won’t chase quick returns but will ensure your money is invested for the long term.
Sometimes, the hardest thing to do as a lawyer is sit back and do nothing. But once your financial plan is implemented, that’s what you need to do – you’ll have a defined strategy which won’t be affected by blips in the market and will be ‘rebalanced’ regularly to ensure it isn’t blown off course.
Most importantly, it lets you get on with enjoying your life and your legal work, and reap the career benefits of your equity partnership.
Kevin Wood is a financial planner and founder of Oak Four Ltd oakfour.co.uk