What Is Cliff Vesting?
Companies often give their employees equity as part of their overall compensation package. Equity represents partial ownership of the company, and offering ownership is a way to incentivize employees—to encourage them to stay and to perform well. However, a company is unlikely to give an employee stock until they have earned it. And that takes time.
An employee is considered "vested" in an employer benefit plan, once they have earned the right to receive benefits from that plan. Cliff vesting is when an employee becomes fully vested on a specified date rather than becoming partially vested in increasing amounts over an extended period.
Typically, plans have a four-year vesting schedule plan with a one-year cliff. Upon completing the cliff period, the employee receives full benefits. Other plans might release benefit amounts over another scheduled period.
- Cliff investing is a way for companies to incentivize employees when they are first hired.
- An employee is considered "vested" in an employer benefit plan once they have earned the right to receive benefits from that plan.
- Employees are considered fully invested on a specified date rather than becoming partially vested in increasing amounts over an extended period.
- Typically, plans have a four-year vesting schedule plan with a one-year cliff. Upon completing the cliff period, the employee receives full benefits.
Understanding Cliff Vesting
Employees choose to provide various benefits to employees in return for their loyalty and service and to attract and retain them. Those benefits include pensions and retirement plans such as a 401(k) or 403(b), and assets such as equity.
While any vesting plan must meet minimum standards set by the Internal Revenue Service (IRS), most employers will require the employee to demonstrate commitment over a period before the employer will support the employee with financial benefits in the form of vesting.
An example of cliff vesting would be when an employee is fully vested in a pension plan after five years of full-time service. Partial vesting would occur if the employee were considered 20% vested after two years of employment, 30% vested after three years of employment, and 100% vested after 10 years of employment. In a cliff vesting pension plan, if an employee leaves the company before becoming fully vested, they would not receive any retirement benefits.
Types of Cliff Vesting
Vesting schedules can be time-based, milestone-based, or a mix off time-based and milestone-based. Time-based stock vesting allows employees to earn equity over time. Typically, an employee will be required to remain at the company for at least a year to exercise any options.
For milestone vesting, an employee earns options or shares after completing a specific project or when the company or the employee reaches a business goal.
Hybrid vesting combines time-based and milestone vesting. An employee must have been with a company for a certain amount of time and reached a milestone before they receive options or shares.
Special Considerations for Cliff Vesting
To a new employee, cliff vesting can seem like a risky proposition. The contract or arrangement could terminate for some reason just before the initial qualifying period is complete. For example, there may be a hostile takeover of the company or a buyout whereby new policies nullify the cliff.
Chris Chen, CFP®, CDFA®
Insight Financial Strategists LLC, Waltham, MA
Cliff vesting relates to employer-sponsored retirement plans, employee stock option plans, and restricted stock units.
The term describes the schedule in which an employee's benefits are paid (or "vested") all at once on a given date. Alternatively, vesting can happen over time on a defined schedule. This is known as gradual vesting. As an example, an employee’s stock options could vest either at a rate of 20% a year for five years (gradual vesting) or all at once after five years (cliff vesting).