A plan sponsor’s predetermined vesting schedule defines the amount of ownership a plan participant has in employer contributions. Vesting schedules can vary by retirement plan. One of the main reasons a plan sponsor may choose to add or change a vesting schedule is to attract and retain employees.
When thinking about vesting, remember that participants are always 100% vested in their own plan contributions. “Vested” money is the amount the participant is legally entitled to at the time of employment termination.
For employer contributions, vesting generally is computed based on the number of years of service worked with over 1,000 earned hours. Plan documents can vary in the computation period: Some use the anniversary of the participant’s participation, while others use the plan year after the first anniversary.
Not all employer contributions are subject to a vesting schedule. For example, a safe harbor match is always immediately 100% vested when it’s allocated. But both regular matching and profit sharing contributions may be subjected to a vesting schedule.
There are three types of vesting schedules:
1. Immediate vesting. This is exactly what it sounds like — participants are immediately 100% vested in the employer money allocated to them.
Immediate vesting can help attract employees, and it’s the simplest type of vesting to administer. But it doesn’t provide an incentive for employees to stay with the company, and it can be costly when employees depart after a relatively short period of employment.
2. Graded vesting. This kind of vesting schedule can vary, but under the Pension Protection Act of 2006 (PPA), graded vesting schedules cannot be more than six-year graded. A graded vesting schedule can be more, but not less, generous than the following schedule:
|Least-generous graded vesting schedule|
|Years of Service||% vested|
Some plan sponsors opt for a more-generous graded vesting schedule in which a participant is vested 20% after the first year, with 20% vesting each year afterward until the participant is 100% vested at five years. Others are even more generous, vesting participants with 25% after the first year, and an additional 25% for the next three years, resulting in 100% vesting after the fourth year.
More-generous vesting schedules can attract employees but may be less effective in retaining them and can increase costs when employees depart. Less-generous vesting periods may be less effective in attracting employees, but they can be more effective in retaining them and reduce costs if employees leave before the vesting period is over.
3. Cliff vesting. Under this type of vesting, a participant isn’t vested at all in employer contributions and then, like falling off a cliff, becomes 100% vested all at once. Under the PPA, a cliff vesting schedule can’t be more than a three-year cliff as follows:
|Least-generous cliff vesting schedule|
|Years of service||% vested|
A two-year cliff would be another option, under which a participant would be 0% vested after the first year and 100% vested after the second. Cliff vesting might be used by employers that want to retain employees for a certain period of time before vesting, such as restaurant or retail businesses that can have high turnover rates.
Other vesting issues
Determining the vested portion of a participant’s account is important when calculating amounts available for loans and hardship distributions. For example, a participant cannot take more than 50% of his or her vested account balance — up to $50,000 — for a loan.
Plan sponsors must provide an annual notice to participants indicating the employer matching provisions. You can change a vesting schedule, but benefits cannot be taken away from a participant. For example, if you have an employer match using a five-year graded vesting schedule, you can’t amend the plan to a six-year graded vesting schedule. However, you could amend the plan to a four-year graded vesting schedule or even to immediate vesting.
If you decide to change a vesting schedule to allow for a shortened grade, set up a new source “bucket” for the employer match money that’s deposited after the amendment. This segregates the employer match money by vesting schedule so it’s clear which vesting schedule is applicable to the new source money.
Getting it right
Keep in mind that a plan sponsor can have either a graded vesting schedule or a cliff vesting schedule on an employer contribution source, but not both. All vesting schedules must be in the plan document, available to participants on their request. By choosing the right vesting schedule, you can help ensure your plan will meet your goals.