Law firms are holding on tight to the roller coaster that is 2022. In November 2021, RSM explained that law firms were not guaranteed another profitable year despite strong demand and rate increases. Fast forward to May, when the Thomson Reuters Law Firm Financial Index (LFFI) for the first quarter of 2022 reported a third consecutive quarterly decline that pushed the index to its lowest point in the entire pandemic.
Despite steady growth in demand for law services (2.7%) and lawyer billing rates (5%) in the first quarter of this year, according to Thomson Reuters, persistent labor market challenges and inflationary pressures sent direct and overhead expenses skyrocketing far higher, at rates of 13.1% and 9.9%, respectively.
These conditions spark two critical questions: Why is this happening; and when will it end?
The key contributor to the increase of direct expenses is the persistent constraints in the labor market.
The economic recovery and resurgence of demand in 2021 caused the gap between labor vacancies and hires to widen to an unprecedented degree. As unemployment levels and jobless claims settled to pre-pandemic levels, a labor supply shortage encouraged firms to increase salaries as both an offensive and defensive strategy to attract and retain precious talent.
Unfortunately, a key problem in the labor market is that inflation is eating into the monetary gains that professionals enjoyed as law firms increased salary rates last year.
The graph below compares national average hourly earnings to real average hourly earnings adjusted for inflation. As you can see, inflation has adjusted the real average hourly earnings to near pre-pandemic levels, causing professionals to feel no better off financially despite notable salary increases.
This helps explain the pessimism among law firms that the LFFI captured. Their main strategy to attract and retain talent has been muted by inflation and simultaneously threatened previous profit margins.
From the third quarter of 2020 until the second quarter of 2021, law firms enjoyed four consecutive quarters of negative growth rates for overhead expenses (decreases of 3.7%, 5.8%, 8.5% and 4.1%). Although a resurgence of expenses was expected as businesses returned to pre-pandemic operations, the growth rates have been amplified due to labor market constraints, as well as the highest inflation in decades.
The chart below illustrates how firms’ strategy of increasing time, attention and resources on attracting and retaining talent led to expenditures on recruiting, support staff benefits and support staff compensations. Additionally, an increase in technology expenses is likely driven by labor constraints and the desire to become a more efficient and automated firm.
In the big picture, two major contributing factors to heightened direct and overhead expenses are labor market and inflation.
Looking forward: Labor constraints and inflation impact
The U.S. economy shows signs that labor market constraints are easing. New jobless claims last week were above pre-pandemic levels for the second consecutive week, the first time they have been this high since February.
Job vacancies in professional and business services also declined slightly in April, shaving off almost 150,000 vacancies from the report in March. It’s important to note that, overall, job vacancies remain unprecedently high, but this month-over-month decline gives us reason to be optimistic.
Inflation is expected to remain a critical factor for all industries. In May, inflation in the United States reached a 40-year high at 8.6% from a year ago. The Fed responded by raising rates by 75 basis points in June—the biggest single rate hike since 1994.
RSM economists forecast that the Fed will continue to raise the policy rate in July and September by 50 basis points each time. These cooling measures adjust economic projections, with unemployment expected to rise to 3.7% by the end of 2022, which would release additional pressure on the labor market.
Although these monetary policies give a glimmer of hope for a reprieve to inflation and labor constraints, it’s clear that these issues will be present for the majority of 2022.
Driving operational efficiencies should remain a top priority in order to control overhead costs. Law firms should continue to invest in process improvements and automation technology that can drive internal efficiencies in order to decrease the need to add administrative headcount to get the job done.