For law firms that rely on increased compensation, the economy says you lose

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Diving into the recent legal market report, we see an industry that is showing resilience, but could that be derailed by rising compensation costs?

The Thomson Reuters described a legal industry embroiled in an escalating war for talent. Since major law firms like Milbank began increasing partner salaries in early 2021, the market has grown every month since by increasing the average partner salary.

By the end of the second quarter of 2021, associate compensation growth per full-time equivalent (FTE) had reached 5.9% on a rolling 12-month average. By November, that growth had skyrocketed to 11.3%, with no end in sight.

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Law firms are slow to change, and even in the face of a crisis, they implement their traditional strategy. To that end, companies began steadily increasing compensation, relying on higher wages to maintain retention. Depending on the underlying economics, however, this isn’t just a bad strategy, it’s a doomed strategy.

In economics, the work-leisure model is a way of conceptualizing how people make decisions about their jobs and wages. Fundamentally, it’s an acknowledgment that all workers make a trade-off: do they want to earn more money but enjoy fewer hours of personal time? Or do they want more leisure at the cost of less income? We can show this as a graph, with leisure hours on the X axis and income on the Y axis. In this system, a salary takes the form of a line, drawn from the end of the X axis to the upper point of the Y axis. This upper point symbolizes the theoretical maximum an employee could earn if he devoted all his available time to work, while the opposite point of the line symbolizes the minimum income he could earn. would win if he only enjoyed leisure.

To complete the model, we need to add the worker or in this case, the associate. This is done by including a utility curve (also known as indifference curve) which signifies an exchange of income and leisure in which the young associate derives the same satisfaction. As long as the associate is somewhere along this line, he is indifferent to the exact combination of work and leisure. However, if another law firm offered the partner a higher offer (that is to saymore money for the same effort), the partner would shift to a new utility curve that we plotted above.

With all of this in place, we can determine how many hours people will work and for what wage, as they will select the point at which the wage line comes into contact with the highest utility curve.

Associates permanently reside on the left side of this graph, working absurdly long hours for very high pay. This is where the first problem for law firms arises: how to slow the increase in marginal costs. The utility curve is a curve for a reason. As leisure hours decrease, associates place increasing value on those remaining hours. So the compensation that law firms have to offer their associates for those few remaining hours is growing rapidly. The utility curve eventually becomes infinite as the partners refuse to give up any other vital leisure time. This is why law firms cannot simply pay partners to work indefinitely, the hourly cost eventually becomes too much for even a law firm to bear.

This, of course, is not new. Companies have recognized a limit to this arrangement and have historically found a comfortable zone of stability. The expectation was set for a certain salary for a certain number of hours from their associates.

And then the COVID-19 pandemic hit, and millions of people across all industries re-evaluated their careers and lifestyles. En masse, utility curves shifted, upsetting the balances law firms had managed to achieve with their associates. The same combination of wages and leisure caused several utility curves to drop because, rather than the job changing, the associates themselves changed. Simultaneously, corporations began a bidding war for talent as the value of associates skyrocketed while simultaneously the dissatisfaction of said associates grew.

The solution seemed obvious to many law firms. If the talent war is a bidding war, the way to win is to keep pace. As we said, however, companies that engage in this strategy are not just destined to see declining returns, they are destined to lose.

Story of two law firms

For example, let’s say a law firm seeks to retain talent and does so by continually increasing salaries. As noted earlier, since lawyers are already on the far left of the work-leisure graph and due to the near verticality of the utility curve at this point, compensating associates more Won’t do make them more productive. Worse still, the recruiting business doesn’t really make its associates any happier. A little math shows that the utility increases from wage increases in the upper right territory are just as marginal as the productivity increases, that is, very little. The law firm that retains him has dramatically increased costs, hasn’t realized any productivity gains, and his partner is only slightly happier.

Now suppose there is a second company, which is looking to recruit in the current market. Their strategy is simple: match the salary and demand fewer billable hours from their new hires. If the only thing that keeps associates in a business is money, then by giving them the same pay for less work, another business can attract them. It’s not a terrible solution to gaining talent. Even if the profit generated by this new lawyer will be less, taking into account the increase in direct costs and the reduction in the number of hours billed, it will still be a positive profit generation for the firm.

What is the response of retention companies to this strategy? If companies follow the traditional strategy, they raise wages even further. In response, the recruiting firm matches that salary and keeps the hours lower. The process repeats indefinitely until the economic profit of this layer reaches zero.

Who wins and who loses? Well, obviously associates win because they reap all the fruits of their labor, while working the same hours or less. Companies that engage in a pure compensation strategy lose out. By engaging in an endless series of one-upmanship, companies fall prey to the wickedness of a commodity market where the highest bidder takes all. The only balance found by companies and the only end point of this strategy is when all of a partner’s potential economic profit has been squeezed out in wage negotiations. If companies treat the talent market like a commodity market, then the economics of a commodity market will take hold and drive profit to zero.

So what should companies do? This problem is not new, other industries have faced it and found solutions. By emphasizing a more tribal sense of belonging, companies can create a connection with their associates that goes beyond a transactional nature. Moreover, these mandatory Strategies do not fall prey to this ever-increasing spiral of rising costs, as associates may reject offers that may be better financially because they have been imbued with the feeling that they are gaining happiness through their jobs. in their current company.

If law firms can enable their associates to find purpose and find happiness through some means other than monetary compensation, perhaps those firms can escape the harsh economic demands of an open market.

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The opinions expressed are those of the author. They do not reflect the views of Reuters News, which is committed to integrity, independence and non-partisanship by principles of trust. Thomson Reuters Institute is owned by Thomson Reuters and operates independently of Reuters News.

Bryce Engelland

Bryce Engelland is an industry analyst focusing on the legal market and providing thought leadership for Thomson Reuters. It examines law firm financial data and economic trends to provide insight into the state of the legal industry. Bryce is a graduate of Wichita State University, where he earned a master’s degree in economics and a bachelor’s degree in international business.

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