Your vesting period is an important factor to consider in employer benefits because it determines when you own your retirement assets or equity compensation. In this article, we’ll cover the basics of vesting, as well as how to determine your vesting schedule.
What is vesting?
Vesting is a process that rewards long-term employees with potential benefits such as more ownership of their employer-sponsored retirement funds or equity compensation.
For example, an employer might offer an employer match to your 401(k), but you don’t technically own the match until it vests. If someone is 100% vested, they have 100% ownership of their 401(k) assets — even amounts the employer contributed. If the employee changes jobs or retires, they do not have to forfeit any of the 401(k) assets.
However, if someone is only 50% vested, they only have 50% ownership of the assets in question. If they leave their job , they could potentially forfeit 50% of the matching dollars from the employer or equity grants.
What is a vesting period?
The vesting period is the schedule over which you gain ownership of various benefits.
Common vesting periods are 3 to 5 years, but employers can choose a variety of different schedules, too.
Restricted stock units (RSUs) and stock options are commonly offered by employers as part of an incentive compensation structure. For example, someone may be granted 200 RSUs at hire or over certain intervals during their employment. However, they don't actually own the stock until the grants have vested. The employee slowly gains ownership in the stock over time, perhaps 20% each year on a 5-year schedule. Here’s what that would look like:
- 1 year after the grant, they have 20% ownership
- 2 years after the grant, they have 40% ownership
- 3 years after the grant, they have 60% ownership
- 4 years after the grant, they have 80% ownership
- 5 years after the grant, they have 100% ownership
If the employee leaves in year two after the grant, they would only be able to take 40% of the stock with them while the rest would be forfeited. Vesting periods are designed to entice employees to stay with a company as long as possible.
Types of vesting schedules
Employers can choose from several types of vesting schedules. Understanding which one you're dealing with helps you understand how your decisions might impact your retirement benefits or company stock.
Immediate vesting
Immediate vesting occurs when there is no waiting period for full ownership. For example, with immediate vesting in your 401(k) plan, you can take all the money with you without forfeiting part of the employer match contributions if you leave your job.Pretty straightforward!
Graded vesting
Graded vesting refers to the slow accumulation of ownership rights over time. For example, if the vesting period is four years, you might earn 25% ownership rights every year.
Obviously, immediate vesting is preferable for employees. It means you don't have to worry about waiting to be able to walk away from a job or otherwise transfer benefits without losing some of the value. But graded vesting is more common because it acts as an incentive to keep you at the employer for longer.
Cliff vesting
Cliff vesting1 can mean a few different things, but in general it means there’s a waiting period before something happens. As one example, if an RSU grant has a 3-year cliff with immediate vesting, you’ll need to work for the company for 3 years. Once you hit that 3-year cliff, 100% of the RSU grant will vest and you become the owner of shares. As another example, if your employer has a 1-year cliff for 401(k) matches with a graded 4-year vesting schedule afterwards, you need to work there for one year to hit the cliff, and afterwards 25% of your employer matches will vest per year. So if you leave the employer after two years, you’d be able to take 25% of the employer matches with you.
Special considerations and triggers
There are some times that you may become fully vested without waiting out the entire vesting period. This typically occurs when there is a special consideration or trigger.
A common trigger is retirement. Regardless of where you are in a vesting period, retirement at the appropriate age sometimes causes you to be 100% vested in 401(k) plans. Employees might also become fully vested if their plan ends for reasons outside their control, such as when the employer decides to change plan providers.
Another example is with stock options provided as benefits or compensation for start-up employees. There might be a provision that creates a trigger event if the company is sold or an initial public offering (IPO) occurs. In this case, the trigger event can cause employees to become fully vested in their stock options so that they receive some type of compensation following an acquisition or IPO.
The bottom line
Understanding these kinds of details in your compensation structure is important. It lets you:
- Plan ahead for building wealth
- Helps you make the right decisions about your career and financial future
Do the work to understand benefits such as your retirement plan and equity compensation, especially to figure out when you own the benefits outright.
