Vesting Schedule: Everything You Need to Know
A vesting schedule is an incentive program set up by an employer which, when it is fully "vested," gives the employee full ownership of certain assets.6 min read
Vesting Schedule: What Is It?
A vesting schedule is an incentive program set up by an employer which, when it is fully "vested," gives the employee full ownership of certain assets — usually retirement funds or stock options. It is an employer's way of giving employees a reason to stay with the company. To be 100 percent vested means that you are able to take all of your retirement benefits with you if you leave or have been fired.
Example: You are given 5,000 stock options or shares of restricted stock. Your vesting schedule is four years, and 25 percent of the grant vests each year. At the first anniversary of your grant date and on the same date over the subsequent three years, 25 percent of the options or restricted stock "vests," or becomes available to you. Once each portion vests, you can sell the shares. After four years, you have total access to all of the stock options and can do with them what you wish.
What Is Vesting?
Vesting doesn't apply to any money that you put towards your pension account. That is your money and if you leave the company you take that with you. Whenever you make a payment into your retirement plan at work, you are 100 percent vested in your own contributions.
Your employer, however, vests their contributions as a way to get you to stay at the company. The longer you work at a company, the more of the company's contributions you will have access to. If you leave the company before their contributions are 100 percent vested, they keep whatever has not been vested, even though it may be in your account.
Vesting Schedules for Retirement Accounts
There are three main types of vesting schedules:
- Immediate vesting: Employees with this type of vesting plan get 100 percent ownership of their employer's money as soon as it lands in their accounts.
- Cliff vesting: Cliff vesting plans transfer 100 percent ownership to the employee in one big chunk after a specific period of time. Employees have no right to any of the company's contributions if they leave before that period of time, but the day they reach the specific date, they own it all. These are generally no longer than three years.
- Graded vesting: Graded vesting gives employees gradually increasing ownership of matching contributions as time passes, eventually resulting in 100 percent ownership. For example, a five-year graded vesting schedule could give 20 percent ownership after the first year, then 20 percent more each year until employees gain full ownership after five years. If the employee leaves before five years have passed, he or she only gets to keep the percentage that has been vested. Federal law states vesting schedules on retirement plans cannot be longer than six years.
Defined Benefit (Pension) Plans
Defined benefit plans must vest at least as quickly as one of the following two schedules unless the plan is top-heavy. Top-heavy means that each employee receives a fair share of retirement benefit relative to their salary.
- Five-year cliff vesting, where no vesting is required before five years of service.
- Three- to seven-year graduated or graded vesting. The plan must give vesting that is at least as fast as 20 percent in the third year with an additional 20 percent vested each year after that.
When Are Contributions 100 Percent Vested?
- Plan termination: Benefits are 100% vested if the plan is terminated. You are able to take whatever money is in it with you.
- SEP, SARSEP, and SIMPLE IRAs: All contributions to these are fully vested.
- Attainment of normal retirement age: If you reach retirement age before the date stated on the initial vesting schedule, your benefits become 100 percent vested.
- Under a 401(k) plan: Elected deferrals, qualified non-elected contributions, and qualified matching contributions are always 100 percent vested.
Vesting Schedules for Stock Options
Stock options allow the employee to buy company stock at a set price, regardless of what the stock's current market value is. The hope is that the stock's market price will rise above the set price before the stock option is used, allowing the employee to make a profit.
- In a cliff plan, employees get access to all of the stock options on the same date. For example, if employees are given stock options on 100 shares with a five-year cliff vesting schedule, they need to work for the company for five years before they can use any of the options to buy shares.
- In a graded plan, employees are only allowed to exercise a percentage of their stock options at a time. In a five-year graded schedule, employees might be able to buy 20 shares per year until they reach 100 shares in the fifth year of employment.
The most common employee stock options usually have a one-year cliff. This means that the employee needs to work for the company for one year before any shares vest. If the employee leaves the company or gets fired before the year is up, they get nothing. After the first year, the shares vest on a monthly or quarterly basis. Once an employee has worked for the company for four years, the shares are 100 percent vested.
Most stock options are not part of an employee's retirement plan, so their vesting schedules are not restricted by the same federal rules that govern matching contributions.
Graded Vs. Class Year Vesting
Graded vesting treats the value of all the shares equally over time. Class year vesting treats each year's grants differently. Class year vesting extends each amount given over a new vesting schedule, while graded vesting reaches 100 percent at a specific date where all shares are vested.
It is common to use class year vesting combined with a set period of years when all shares would become 100 percent vested. For example, a plan might use a four-year class year vesting schedule and then say that all shares will be 100 percent vested following ten years of employment.
In some cases, the retirement plan or stock options may become 100 percent vested before the set amount of time has passed. This may happen if the employee becomes disabled, dies, or the company is sold. This should be clearly written in the vesting agreement.
Why Do Companies Need Vesting?
Companies should have vesting options for two main reasons:
1. To give an incentive for their employees to stay. By offering additional stock options or pension money for staying longer with a company, it gives employees something to look forward to as time passes.
2. To protect themselves from giving an incentive to bad hires. If a company hires someone and instead of creating a vesting schedule, gives each new employee access to stock options right away, they risk giving away money to people who will not stay for very long. A one-year cliff will protect companies from issuing stock to bad hires because it can often take a few months until it is recognized whether the new employee was a good choice for the company or not.
The Best Vesting Schedule
There is no single best vesting schedule. Companies need to assess the situation on a per-person basis. They will want to give different options to different new hires depending on how much they need that person, how much they want to incentivize that person, and how much it will cost the company if they leave.
The Future of Vesting Schedules
In recent years, many new start-ups have felt that vesting schedules are outdated and have a negative effect on the profit of the company.
New companies are using a sort of loophole to appear as though they are offering vesting schedules on stock options without actually offering anything. They do this by hiring people on a four-year vesting schedule but waiting much longer to go public with the company than four years. This means that if an employee wants to use their stock options, they have to wait until the company has actually gone public (so that there are actually stocks to use).