When people save for retirement, their employers sometimes offer to help by matching some or all of their employees’ contributions to a company-sponsored retirement investment account. Every penny employees save is theirs. But it’s a different story with company contributions. Employers set conditions on the funds they chip in. Companies usually consider how long employees have held their job to determine how much corporate cash to hand over, and when to do it. This is where vesting comes in.
What does vesting mean?
Vesting is the term used to describe a process in which a person gains possession of an asset, property or some other good or benefit. It is a common feature in corporate employee retirement plans, although it also is used in some other types of compensation programs. Simply put, vesting governs when ownership of the funds a company awards a worker passes from employer to employee. Another way to think of vesting is to consider how much money in the account employees actually own and can walk away with at any time.
Once vested, employees enjoy rights over the assets that cannot be revoked or forfeited. The term vested interest refers to employees’ ability to claim assets contributed for later use. Employees who are fully vested own 100% of their retirement money or compensation, wherever that money came from.
Employees who leave their company before meeting the plan’s vesting schedule risk losing at least part of the employer-contributed funds. That’s because the employees do not yet own the full amount, or are not fully vested.
How does vesting work in retirement funds?
Employees with access to a workplace retirement plan like a 401(k) can decide how much of their paycheck to regularly contribute to that account, up to an annual limit. That amount is deducted and secured in the account for employees to access in retirement. Money that employees contribute to their retirement accounts is not subject to vesting—that money is theirs outright.
Employers may also contribute to their employees’ retirement accounts, in what’s known as an employer match. Those contributions may be subject to vesting, which occurs on a company-determined schedule in compliance with federal regulations. The schedule maps out when employees get full ownership rights to employer contributions in their retirement account.
Some generous plans allow employees to become fully vested in company contributions immediately. More commonly, vesting takes three to five years. Some employers even require a full six years at the company.
Companies use two main types of vesting schedules:
- Graded vesting schedule. This type of vesting, also sometimes called graduated or gradual vesting, usually requires a minimum of two full years of service. A common schedule starts at 20% a year and climbs to 100% after several years. Vesting in employers’ contributions takes place incrementally on the anniversary of an employee’s hiring. Employees typically become fully vested after a five or six year vesting period.
- Cliff vesting schedule. This is exactly what it sounds like: Employees become vested in employers’ contributions all at once—like falling off a cliff. Typically employees are not vested at all for the first two years, but become fully vested at the end of the third year.
Employers can choose either graded or cliff schedules, but not both.
Other types of vesting
Vesting can also apply when companies grant employees stock options or award them restricted shares. The options, a right to buy shares at a predetermined price, can only be exercised at some point in the future. Restricted stock consists of shares that the employee can only take possession of after a period of time. In both cases, vesting rules apply, and the employee only gains full ownership of the options or restricted shares according to a vesting schedule.
Pensions and other defined benefit plans are less common today. But they also follow vesting rules, which are established by federal law, and they must adhere to a vesting schedule.
Federal law requires that employees earn the right to receive their pension benefits once they meet normal retirement age and years of service requirements.
Pension vesting follows either a cliff or a graded/graduated schedule. Cliff vesting allows employees to become fully vested after a certain number of years. Federal rules say this can’t be more than five years in the private sector, but employers can choose to allow full vesting sooner.
A graduated schedule allows partial vesting for each year of service starting at 20% with the third year. Vesting increases each year until reaching 100% after the seventh year.
The bottom line
In retirement planning, vesting equals money, so it’s crucial to understand the concept and how it works. Employees who put money into a company-sponsored retirement plan can gain an additional cushion for their later years when their company also contributes to the retirement account—but those retirement contributions may have to vest over time. Other types of corporate compensation, such as stock-option grants and restricted stock awards, may also be subject to vesting rules.