Defined benefit plans and cash balance plans are complex. One question that business owners often ask: what does employee vesting mean and how does is apply to my business?
Retirement plans will generally require contributions for all eligible employees. However, there are ways to improve the plan economics for the owner. This can be accomplished by adding vesting restrictions.
In this post, we will discuss how vesting is applied to employees. We even have an example so you can see how vesting is applied at the individual employee level. Let’s dive in.
Table of contents
What is Employee Vesting?
How Does Employee Vesting Work?
What Are the Vesting Date Options?
Cliff Vesting Vs. Graded Vesting
What happens if an employee does not vest?
Employee Vesting Example
Adam
Bella
Cara
Dave
Ellie
Final Thoughts
What is Employee Vesting?
What does vesting mean? Essentially, it means ownership.
Even though an employee may have received an allocation under a defined benefit plan or cash balance plan, they don’t have a right to the funds until they actually vest.
Some plans are structured with immediate vesting. In this case, the employee has immediate ownership in the funds when contributed. If they leave the company they get to take the funds with them.
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But the IRS allows plans to have up to three year vesting. They also allow graded vesting or cliff vesting (more about this later).
How Does Employee Vesting Work?
So let’s discuss the vesting for each of the employees. First of all, vesting is all or nothing. The employee is either vested in their entire balance or none at all.
Some people assume that employees will vest separately in each year and for each contribution. This is simply not the case. Employee vesting is not applied annually based on a specific allocation.
Once an employee meets the vesting date, they are vested for the entire amount and all future contributions and interest credits.
Vesting does work independent of contributions in one situation. If an employee was hired during a plan year they can normally be excluded from receiving a contribution for the year.
However, for vesting purposes, as long as they worked at least 1,000 hours in the year they would accrue a year of vesting starting on January 1st of that year.
So if an employee was hired on July 1st of a given year and will not enter the plan until January 1st of the following, they will still receive one year of vesting. This is one subtle difference.
Regardless of the vesting schedule provided in the plan document, all employees who reach retirement age (usually 62 or 65) are required to be 100% vested.
Also, please realize that an employee does not have to be employed on the last day of the year (or computation period) in order to receive to receive a vesting credit for the year. The participant only needs to work at least 1,000 hours to be credited for the year of service.
What Are the Vesting Date Options?
I understand that vesting begins and ends with a specific date. How are these dates determined? When does the three year vesting period start?
Your plan document will specify the plan vesting dates that are used. There are basically two different measurement dates.
Date of hire. The start of the vesting period begins when the employee was hired. The date the plan was established is irrelevant. For example, the plan could be implemented during 2021. However, if all the employees were hired in 2015 you can use their respective hire date in 2015 to start the vesting period (they are all of course vested).
Plan year. This is the most common option. The vesting is determined based on the plan year. For example, if a plan is set up in 2021 and all the employees were hired in 2015 then the beginning vesting date for measurement will be 1/1/21. All the years of service before the plan was implemented are excluded.
The plan year option will of course make the most sense for most companies. This is because you don’t want to set up a plan in a give year and have to vest all employees who have been with you long before the plan was set up.
Cliff Vesting Vs. Graded Vesting
There are three vesting schedules that you can adopt. Each can have pros and cons. However, the most common is called “cliff” vesting. Let’s discuss the options.
Immediate vesting based on the contribution date.This one is straightforward. Employees are fully vested in employer contributions once they receive a contribution.
Graded vesting.This vesting schedule is more often used for profit sharing plans. Employees earn ownership gradually as they continue to work at the company. For example, they might earn 20% a year until the employee is 100% vested. If the employee terminates before being fully vested, he or she can only keep the percentage of funds in which they were vested. The IRS allows up to six-year graded vesting maximum.
Cliff vesting. This vesting schedule gives the employee 100% ownership at a certain date in the future. It is all or nothing. The vesting date can be from one year to three years. If the employee terminates before this date, he or she receives nothing. The IRS allows a maximum cliff vesting of three years.
What happens if an employee does not vest?
Any unvested allocations are forfeited back into the plan and will be used to reduce future contributions. The company still gets the tax deduction from the initial contribution.
Employee Vesting Example
We know that vesting questions can be somewhat complex, so let’s look at an example. Let’s assume a company set up a defined benefit plan with the following provisions:
Plan for calendar year 2021 (effective date of 1/1/21)
Five full time employees (excluding owner)
Normal retirement age of 62 and semi-annual entry dates
3 year cliff vesting
Vesting based on plan year and NOT hire date
Benefit crediting and eligibility based on counting hours method
1 year of vesting awarded if 1,000 hours worked during year
We are going to spell out the relevant employee information in the table below.
Name
Birth Date
Start Date
Term Date
Date Vested
Adam
01/19/00
04/17/15
N/A
12/31/23
Bella
11/28/77
10/08/20
N/A
12/31/23
Cara
08/11/92
03/22/21
11/03/23
11/03/23
Dave
03/12/85
08/15/14
10/26/22
N/A
Ellie
05/09/50
7/28/19
N/A
So let’s take a look at how and why each employee is vesting. Along the way, we will examine a few key distinctions.
Adam
This situation is rather common. Adam is not of retirement age and started working at the company five year before the plan was established. He is still employed by the company. Since the plan vesting date will begin on 1/1/21, Adam will be fully vested on 12/31/23. This is straightforward.
Bella
Again, Bella’s situation is rather straightforward. Her vested date will the same as Adam’s even though she was hired five years after him. Remember that all that matters is the effective date of the plan. It does not matter when the person’s employment began.
Cara
Cara’s situation gets a little more interesting. Why is her vesting date before Adam and Bella considering she left the company?
The answer lies in the number of hours worked each year. Remember that these are full time employees, so Cara would have worked over 1,000 hours for years 2021 through 2023.
But you may be asking why Cara gets a year of vesting for 2021 even though the company will not be making a contribution for her for the year.
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Herein lies the measurement differences for contribution years and vesting years. For contribution purposes, Cara would not have been eligible to receive a contribution for 2021 because she would have been eligible for plan entrance on 1/1/22 (she started working in the year the plan was established.
However, since Cara worked 1,000 hours during 2021 she still will be credited for a year of service even though she will not receive a contribution for year. This is an important distinction and should not go unnoticed.
Dave
Dave worked over 1,000 hours for both 2021 and 2022. So he earned two years of vesting service. However, since he left the company in late 2022 he earned less than the three year vesting. As such, his entire defined benefit plan balance (both pay credits and interest credits) is forfeited.
Ellie
Ellie’s situation is unique and should not be overlooked. Since she is over the age of 62 (the plans designated retirement date) she is fully vested in all plan contributions and the three year vesting period does not matter.
We know that older employee will require larger contributions. However, immediate vesting in situations like this can be very challenging for the plan economics and are often overlooked.
Final Thoughts
With a typical plan structure, the goal is to get at least 90% of the plan contributions allocated to the owner. This can be improved when you consider vesting options.
An employee is vested in their Defined Benefit if all or a portion of their benefit is not forfeited when they separate from service. For purposes of vesting, the employer may require a participant to work as many as 1,000 hours in a year to earn a year of vesting service.
The maximum time limits for becoming fully vested are six years with graded vesting and three years with cliff vesting. Employer contributions made to safe harbor 401(k) and SIMPLE 401(k) plans must be fully vested immediately.
Employees must be vested in their employer-sponsored retirement plan, which is one of the requirements under ERISA. This implies that an employee must have a non-revocable entitlement to a share of the plan's benefits.
A common vesting period is four years, often with a one-year cliff. This means that the employee must remain with the startup for one year before any portion of the equity grant vests, after which the remaining equity vests over the next three years.
In a defined benefit plan, an employer can require that employees have 5 years of service in order to become 100 percent vested in the employer funded benefits (called cliff vesting).
A defined-benefit pension plan requires an employer to make annual contributions to an employee's retirement account. Plan administrators hire an actuary to calculate the future benefits that the plan must pay an employee and the amount that the employer must contribute to provide those benefits.
If the company follows a graded schedule, it can require up to seven years of service in order to be 100% vested. But it must provide at least 20% vesting after three years, 40% after four years, 60% after five years and 80% after six years.
For any period that the percentage of benefit plan investors of any class of equity interests in a fund is 25% or more, the fund, and anyone with discretion over the assets of the fund, will be required to comply with the fiduciary standard of care and prohibited transaction rules under ERISA.
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.
The most common choices for vesting periods are three, four or five years. The sponsor may choose any vesting period. If the period is relatively short (i.e., 3 years), “cliff vesting” is often used.
It is typically detailed in your option grant (e.g. 1,000 options over four years). There are three common types of vesting schedules: time-based, milestone-based, and a hybrid of time-based and milestone-based.
With graded vesting, an employee will gradually build their vested amount until reaching 100%. As an example, an employee could reach 20% vested at two years of service and increase 20% each year until they reach 100% vested in the sixth year.
The two most common types of vesting are sole ownership and co-ownership. Sole ownership covers the ways in which an individual can hold title on a property. Co-ownership, on the other hand, is how more than one individual can hold title on the same piece of real property.
Once a pension has vested, you should be entitled to keep those funds, even if you're fired. However, you aren't always entitled to all the money in your pension fund. In some cases, you might lose some, or even all, of your pension.
In simple terms, if you are "vested" in a certain investment asset, it means that you have full ownership and control over it. For example, let's say your employer-sponsored retirement account has $20,000 in it, and you are vested in 75% of the balance.
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.
There are a total of 60 non-excludable employees of the employer. In general, each defined benefit plan must cover at least the smaller of 50 participants, or 40% of the non- excludable employees, which is 24 participants. So, at least 24 participants must be covered in each plan.
In essence, the accounting for defined benefit plans revolves around the estimation of the future payments to be made, and recognizing the related expense in the periods in which employees are rendering the services that qualify them to receive payments in the future under the terms of the plan.
Defined benefit plans provide a fixed, pre-established benefit for employees at retirement. Employees often value the fixed benefit provided by this type of plan. On the employer side, businesses can generally contribute (and therefore deduct) more each year than in defined contribution plans.
In general, the annual benefit for a participant under a defined benefit plan cannot exceed the lesser of: 100% of the participant's average compensation for his or her highest 3 consecutive calendar years, or. $265,000 for 2023 ($245,000 for 2022; $230,000 for 2021 and 2020; $225,000 for 2019)
In the private sector, DB plans have been largely replaced by defined-contribution plans, which are primarily funded by employees who choose investments and bear the burden of investment risk. Companies opt for DC plans because they are more cost-effective and less complex to manage than traditional pension plans.
When you leave a job before being fully vested, the unvested portion of your account is forfeited and placed in the employer's forfeiture account, where it can then be used to help pay plan administration expenses, reduce employer contributions, or be allocated as additional contributions to plan participants.
While a 3(21) advisor acts as an investment advisor, a 3(38) advisor functions as the investment manager for the plan. A plan sponsor who hires a 3(38) advisor is delegating the authority to make changes in the investment lineup to them.
Section 406 (a) of the Employee Retirement Income Security Act of 1974 (“ERISA”) broadly prohibits plan fiduciaries from causing a plan to enter into either a direct or an indirect transaction involving the plan or its assets that have the potential for conflicts of interest.
Service for vesting can be calculated in two ways: hours of service or elapsed time. With the hours of service method, an employer can define 1,000 hours of service as a year of service so that an employee can earn a year of vesting service in as little as five or six months (assuming 190 hours worked per month).
Also known as pension plans or qualified-benefit plans, this type of plan is called "defined benefit" because employees and employers know the formula for calculating retirement benefits ahead of time, and they use it to define and set the benefit paid out.
Any money you contribute from your paycheck is always 100% yours. But company matching funds usually vest over time - typically either 25% or 33% a year, or all at once after three or four years. Once you're fully vested, you can take the entire company match with you when you part ways with your job.
This is the most common option. The vesting is determined based on the plan year. For example, if a plan is set up in 2021 and all the employees were hired in 2015 then the beginning vesting date for measurement will be 1/1/21.
Each stock option may carry a different vesting schedule. If employees, for example, are granted options on 100 shares with a five-year cliff vesting schedule, they must work for the company for five more years before they can exercise any of the options to buy shares.
Joint tenancy with right of survivorship (JTWROS) This is often a common vesting for married couples, but it also applies to family members planning to own a property together. ...
Community property with right of survivorship. ...
What is the 7 percent rule? The 7 percent rule is a retirement planning guideline that suggests you can comfortably withdraw 7 percent of your retirement savings annually without running out of money.
Before vesting, no pension benefits have been guaranteed. If individuals enrolled in a pension plan leave employment before vesting, they are only entitled to receive back their own contributions.
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.
Perhaps the biggest disadvantage of choosing a defined benefit plan is that the employer usually requires a minimum amount of service for the ultimate beneficiary.
To be eligible for benefits, an employee must have worked a set amount of time for the company offering the plan. In most cases, an employee receives a fixed benefit every month until death, when the payments either stop or are assigned in a reduced amount to the employee's spouse, depending on the plan.
To be fully vested, an employee must meet a threshold as set by the employer. This most common threshold is employment longevity, with benefits released based on the amount of time the employee has been with the business.
If the company follows a graded schedule, it can require up to seven years of service in order to be 100% vested. But it must provide at least 20% vesting after three years, 40% after four years, 60% after five years and 80% after six years.
Vesting schedules longer than 4 years allow you to incentivize employees for longer periods, but will make recruiting more difficult because most employees' alternative job offers will have 4 year vesting. Vesting schedules shorter than 4 years have the opposite problem.
“Vesting” in a retirement plan means ownership. This means that each employee will vest, or own, a certain percentage of their account in the plan each year. An employee who is 100% vested in his or her account balance owns 100% of it and the employer cannot forfeit, or take it back, for any reason.
Before vesting, no pension benefits have been guaranteed. If individuals enrolled in a pension plan leave employment before vesting, they are only entitled to receive back their own contributions.
When you leave a job before being fully vested, the unvested portion of your account is forfeited and placed in the employer's forfeiture account, where it can then be used to help pay plan administration expenses, reduce employer contributions, or be allocated as additional contributions to plan participants.
Introduction: My name is Clemencia Bogisich Ret, I am a super, outstanding, graceful, friendly, vast, comfortable, agreeable person who loves writing and wants to share my knowledge and understanding with you.
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