Employers may contribute matching retirement funds, shares of company profit, or stock options as part of an employee’s compensation package, based on a certain cadence known as a vesting schedule.
The vesting schedule is a set of requirements employees must meet in order to become “vested” and gain ownership of the assets the employer is providing. These usually include a certain amount of time at the company, but hitting specific performance benchmarks may also be a part of the vesting contract.
An employee is fully vested when they receive ownership of a portion of, or all of, the assets their employer offers. If the employee were to leave the company before the assets were fully vested, they would lose out on some or all of those contributions/profits/stock options.
What Is a Vesting Schedule?
A vesting schedule is essentially a way to incentivize employees to stay with a company for a period of time, and penalize those who break their contract early. The reward for remaining with the company may include stock options or restricted stock units, retirement plan contributions (also known as the employer match), or other rewards.
So how does an individual know when they are partially or fully vested? They can ask their employer for a vesting schedule, which tells them the conditions they must meet or the dates that must be reached before vesting begins.
Employees who are partially vested may not be entitled to the full amount of the assets. These employees may not meet certain requirements, such as years spent with the company or hours worked during the year, for example. Those who are not “vested” are typically not entitled to any assets at all.
Three Types of Vesting Schedules
Vesting schedules may come in a few different varieties: immediate, graded, and cliff vesting.
Immediate Vesting
Immediate vesting schedules give employees full ownership of assets as soon as the assets hit their accounts. That means employees are 100% vested when their employer makes a contribution.
For example, under an immediate vesting schedule, if an employer makes a matching contribution to a retirement account, that contribution belongs to the employee regardless of any other conditions. The employee is now free to do what they will with the contribution.
Graded Vesting
A graded vesting schedule increases the portion of vested assets over time. Typically as an employee’s tenure at a company increases, the amount of vested assets gradually increases — until the employee eventually owns 100% of the assets.
If the employee should leave the company before the vesting period is over, they will only be entitled to the portion of the assets in which they are already vested.
Graded vesting schedules are usually no longer than six years for retirement plans, according to federal guidelines, though employers may choose to use a shorter vesting schedule. With a hypothetical six-year vesting schedule, an employee might be 0% vested for their first two years of employment and 20% vested every year after that.
Cliff Vesting
This type of vesting schedule transfers 100% of assets to employees after a certain amount of time has passed. For example, an employee may need to work at their job for two years before they are fully vested. If they separate from employment for any reason before that period is up, they aren’t entitled to any of the assets.
Cliff vesting schedules for retirement accounts are three years at most, according to federal guidelines, but may be shorter.
Vesting and IRAs
Most people might be familiar with traditional IRAs and Roth IRAs, which individuals can set up and contribute to themselves. But there are a couple of IRA options that employers can contribute to as well, including SEP and SIMPLE IRAs.
Employers may offer SIMPLE IRAs in place of a 401(k). They can then offer funds that match employee contributions, or they can make non-elective contributions, money they put in an employee’s account regardless of how much that employee has contributed themselves.
A SEP IRA is a retirement plan available to self-employed workers and small business owners. Unlike with other IRA plans, with a SEP IRA employees do not make contributions. Employers, including the self-employed, make contributions for them. Self-employed individuals act as their own employer and employee.
By law, required employer contributions to SEP IRAs and SIMPLE IRAs are immediately vested. This goes for any other IRA-based plan as well.
Vesting and 401(k)s
When you contribute to your 401(k), your employer may offer matching contributions to incentivize you to save at least enough to make the match.
While your own contributions to your 401(k) are 100% yours immediately, your employer may decide to give you ownership of the employer match funds according to a vesting schedule.
It’s important to know the difference between your vested 401(k) balance and your overall balance. Your 401(k) may offer a variety of different vesting schedules, the terms of which are laid out in the plan document. Some plans offer immediate vesting, while others may offer cliff vesting after up to three years of service, or a graded vesting system in which an employee’s vested percentage grows over time.
When Must Employees Be 100% Vested
A retirement plan’s “normal retirement age” is the age set by the plan at which an employee is eligible to receive their full accrued benefits. In the case of annuity payments or other installment payments, this is the date employees can begin receiving payments. According to government rules, employees must be 100% vested by the time they reach normal retirement age.
Additionally, employees must be immediately 100% vested in their accrued benefits if an employer decides to terminate a plan, including for the following reasons: voluntarily; as part of bankruptcy proceedings; when the company is sold; or because of a switch to another retirement plan. At such a point, employer matching contributions and any profit sharing is fully vested regardless of any previous vesting schedule.
Sometimes employers will terminate only part of a retirement plan — for example, if a factory closure forces 25% of the company workforce to be laid off. In this case, workers affected by the partial termination have the same vesting rights as those affected by a full plan termination.
Vesting Stock Options
Employee stock options offer employees the chance to buy company stock at a predetermined price, and are often offered on a vesting schedule as well. Employees are often not allowed to buy the stock — also known as exercising their option — until they are vested.
As with other types of compensation, vesting can follow a number of schedules, including graded scheduling, which allows employees to exercise their stock option gradually, and cliff scheduling. In some cases employees may be granted stock options that are immediately vested.
Once a stock option vests and an employee exercises it, they can sell the stock or hang on to it and hope the value appreciates.
Restricted stock units (RSUs) are another form of compensation in which employees are promised a specific amount of stock at a later date. While there are some differences between ESOs and RSUs, one similarity is that both may follow a vesting schedule and don’t belong to the employee until they are vested.
Employees who receive RSUs from a private company — a company whose shares don’t trade on the open market — may not be able to sell them until the company goes public in an initial public offering.
Why Companies Choose to Use Vesting
The different vesting schedules and the rules around them can get complicated. So why would an employer go through all that trouble? By using vesting schedules, employers are trying to align employees’ incentives with their own. It can be time consuming and costly to find new employees, so when an employer finds someone they like, they want them to stick around. Vesting schedules are one way employers can tempt employees to stay with the company for a certain period of time.
Some types of compensation, such as stock options, add another layer of incentive to the mix. That’s because as a company flourishes, that company’s stock should theoretically become more valuable, incentivizing workers to work hard to keep the company successful.
Additionally, having some time before an employee is fully vested in their benefits allows companies a bit of a trial period. If a new hire doesn’t work out, the company can let them go without owing them additional benefits.
How to Find out About Your Vesting Schedule
It’s critical to know how and when employer contributions to retirement accounts vest. That way, individuals can make informed decisions about when to leave their jobs while minimizing the amount of money they’re leaving on the table. For example, to make the most of their benefits, an employee with 12 months to go before they are fully vested may want to hang on to their job for another year before they start looking for a new one.
To fully understand an employer’s vesting policies, employees can speak with a representative in their human resources department. They may also get details of their retirement plan by reading the summary plan description, which lays out how it operates and what it provides. Individuals may also check their annual benefits statement. This statement should reflect an employee’s accrued and vested assets, and it may lay out what assets an employee will forfeit upon termination.
The Takeaway
Vesting schedules are a tool used by employers to entice employees to stay with the company by offering full monetary or stock contributions after a certain period of employment. There are three different types of vesting: immediate, cliff, and graded.
For employees, it’s important to understand the vesting schedule of one’s retirement plan, stock options, or RSUs. This information can help guide career decisions as well as investment decisions.
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