What is Vesting?

Vesting is like a kid waiting for Christmas to open presents…

As a kid, you might have received Christmas presents from your parents, grandparents, and other relatives. As you got closer to Christmas, you would accumulate the gifts and stash them under the tree. While the presents had a label with your name, they didn’t actually become yours until you opened them. Maybe you could open some presents on Christmas Eve, or maybe you had to wait until Christmas Day, but you had to wait. Likewise, some employer contributions to your retirement plan may be subject to a waiting period (vesting schedule) before they truly become yours.

Vesting refers to the ownership of contributions to a retirement account (e.g., a 401(k) plan), which is an account that allows employees to put aside and invest a portion of their wages for retirement. In some cases, employers might contribute to the account as well.

The employee’s own contributions to a retirement account are typically vested immediately. But when it comes to the contributions that employers make to the retirement account, you don’t always gain ownership right away, For example, among retirement plans administered by Vanguard, nearly half of employers provide 100 percent vesting of employer contributions to employees right away. However, other employers require employees to complete vesting requirements before the company contributions become their property.

Vesting requirements vary per plan. Typically, employers use a vesting schedule, which indicates the number of years of service that an employee must complete before gaining partial or full ownership of company contributions.

Vesting schedules can be grouped into two broad categories.

You gain 100 percent ownership after completing a minimum number of years of service. If you leave the company prior to the minimum of years, under cliff vesting you would lose all employer contributions.

Let’s assume that a company has a cliff vesting schedule in which the employee gains 100 percent vesting after four years of service. If you leave prior to completing four years of service, then you lose all employer contributions.

You gradually gain ownership of employer contributions after completing a certain number of years of service. If you leave the company, you may retain a portion of the employer contributions according to the graded vesting schedule.

Let’s assume that a company has a graded vesting schedule in which the employee gains 20 percent vesting of employer contributions for every year of completed service, starting the second year. In this example, you would earn 20 percent vesting after the second year and an additional 20 percent every year until reaching 100 percent vesting after the sixth year. If you were to leave the company after the fifth year, you would have 80 percent vesting of employer contributions.

One of the main purposes for companies to use vesting is to retain employees. Some companies may be concerned that if they provide 100 percent vesting of employer contributions immediately, some employees may just take the money and leave.

By setting up a vesting schedule, companies can create a financial incentive for employees to stay longer. For example, if a company requires you to work for three years to gain 100 percent ownership of employer contributions to your retirement account, you are essentially being rewarded to stay for three years.

Companies might also use vesting to reduce employee benefit expenses. If an employee were to leave, employer contributions that haven’t vested yet would go back to the company.

To be vested in a 401(k) means that you own the contributions. Typically, employee contributions to a 401(k) are 100 percent vested immediately. However, employer contributions may be subject to vesting requirements. The rules vary per plan and may grant you full or partial ownership.

A vesting period is the minimum amount of time that you must be employed to gain either full ownership (cliff vesting) or gradual ownership (graded vesting) of the employer contributions to your retirement plan.

Typically, a vesting period is measured in increments of years of completed service. For example, you might have to complete one year of service for a 20 percent vested interest in employer contributions and an additional year of service for another 20 percent.

The most common 401(k) vesting period for employer contributions is zero — meaning that employees would gain ownership immediately. For example, nearly half of the retirement plans administered by Vanguard are immediately vested.

Among the plans administered by Vanguard, three out of 10 plans have a graded vesting period of five to six years for employer-matching contributions. In this example, an employee would gradually earn ownership of employer-matching contributions until gaining full ownership at the end of the fifth or sixth year of employment.

Vesting starts on the date set by a plan’s vesting schedule, which varies from plan to plan.

Let’s review some examples of vesting start dates:

• Two-year cliff vesting: Vesting starts after an employee has completed two years of employment. You would gain 100 percent ownership of employer contributions at the end of your second year of employment.
• Three-year graded vesting: Vesting starts after an employee has completed one year of employment. You would gain 33.33% of the ownership of employer contributions at the end of your first year of work and an additional 33.33% percent at the end of two years of employment.

The way a vesting schedule works depends on the type of vesting used by the plan — typically either cliff vesting or graded vesting.

Under a cliff vesting schedule, an employee gains 100 percent ownership after completing a number of years of employment. For example, under a one-year cliff vesting schedule, you would gain and retain 100 percent vesting of employer contributions after completing one year of service.

Under a graded vesting schedule, an employee gains partial ownership (typically, a percentage) of employer contributions, and additional ownership of those contributions each year until reaching 100 percent ownership. For example, under a two-year graded vesting schedule, you would gain 50 percent ownership of the employer contributions after your first year of service and the remaining 50 percent after the second year.

To find out if your 401(k) is vested, you need to consult your plan’s guidelines.

• If your 401(k) plan is managed in-house, contact your employer or the human resources department to request a copy of your 401(k) plan’s guidelines.
• If your 401(k) plan management is outsourced, contact your plan’s administrator or check the plan’s online portal, if available.

If there are some funds in your 401(k) money that haven’t vested yet, they remain the property of your employer until you meet the vesting requirements.

If your plan is subject to vesting, you may notice two balances in your 401(k) statement: your total balance, and your vested balance. The difference between the total balance and the vested balance is your non-vested 401(k) balance. While that remaining balance isn’t your property yet, it will continue to change in value according to your investment selections.

If you leave a company before you’re vested, you would lose any non-vested contributions. The non-vested balance of your retirement plan goes back to the employer, while you keep your vested account balance.

Knowing the vesting rules of your 401(k) plan is part of a good retirement planning strategy.

In stock ownership, vesting typically involves restricted stock or stock options that employees receive as part of a compensation package. Once they are vested after a certain time period or other requirements are met, restricted stock units (RSUs) provide employees shares in the company. Stock options give employees the right to buy the company’s shares at a certain stock price once the vesting requirements are met, but you don’t have to exercise the right to buy the shares.

Examples of vesting requirements for stock ownership include:

• Time: A vesting schedule that is based on a timeline, such as completing one year of employment.
• Milestone: A vesting schedule that requires you to complete a certain project (e.g., complete a merger between two companies) or reach a certain milestone (e.g., generate $1M in sales).
• Hybrid: A vesting schedule combining time and milestone requirements.