What Is Cliff Vesting?
Cliff vesting is the process by which employees earn the right to receive full benefits from their company’s qualified retirement plan account at a specified date, rather than becoming vested gradually over a period of time. The vesting process applies to both qualified retirement plans and pension plans offered to employees.
Companies use vesting to reward employees for the years worked at a business and for helping the firm reach its financial goals. Graduated vesting, in which benefits accelerate with time, is the opposite of cliff vesting.
- Cliff vesting refers to the vesting of employee benefits over a short period of time.
- Startups use cliff vesting commonly because it helps them evaluate employees before actually committing to benefits.
- Cliff vesting comes with pros and cons for employees.
Understanding Cliff Vesting
Cliff vesting is more commonly used by startups because it enables them to evaluate employees before committing a full range of benefits to them. For employees, cliff vesting can be an uncertain affair with pros and cons. While it offers the advantage of cashing out quickly, cliff vesting can be more risky for employees if they leave a company ahead of the vesting date, or if the company is a startup that fails before the vesting date.
In some cases, an employee can also be fired before the vesting date. This means that they lose access to the benefits promised earlier. The typical cliff vesting period is five years. Upon maturity of the vesting period, employees can roll over their benefits into a new 401(k) or make a withdrawal.
Defined Benefit vs. Defined Contribution Plans
When an employee becomes vested, the benefits the worker receives are different depending on the type of retirement plan offered by the company. A defined benefit plan, for example, means that the employer is obligated to pay a specific dollar amount to the former employee each year, based on the last year’s salary, years of service and other factors.
On the other hand, a defined contribution plan means that the employer must contribute a specific dollar amount into the plan, but this type of benefit does not specify a payout amount to the retiree. The retiree’s payout depends on the investment performance of the assets in the plan. This type of plan, for example, may require the company to contribute 3% of the worker’s salary into a retirement plan, but the benefit paid to the retiree is not known. The Pension Protection Act of 2006 recommends a 3-year cliff vesting period for defined contribution plans.
Examples of Vesting Schedules
Assume that Jane works for GE and participates in a qualified retirement plan, which allows her to contribute up to 5% of her annual pre-tax salary. GE matches Jane’s contributions up to a cap of 5% of her salary. In year one of her employment, Jane contributes $5,000 and GE matches by putting in another $5,000. If Jane leaves the company after year one, she has ownership over the dollars she contributed, regardless of the vesting schedule for the amount GE contributed. But whether she has access to GE's $5,000 contribution depends on whether GE used cliff vesting and if so, what that schedule looks like.
GE, Jane’s employer, is required to communicate the vesting schedule to employees and report the qualified retirement plan balance to each worker. If GE set up a four-year vesting schedule, Jane would be vested in 25% of the company’s $5,000 contributions at the end of year one. On the other hand, a three-year schedule using cliff vesting means that Jane is not eligible for any employer contributions until the end of year three.