- Vesting refers to an employee’s ownership of their retirement plan or stock options.
- Employers typically set vesting schedules that grant ownership incrementally over a fixed period of time.
- For newer companies, venture capitalists often want longer stock-option vesting periods for founders.
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Vesting in retirement and stock-incentive plans refers to how much ownership an employee has in them. A fully-vested employee has total ownership of the contributions made into a retirement account by an employer and can fully exercise stock options they’ve been awarded. If an employee were to leave a company before becoming fully vested, they would forfeit whatever percentage of employer contributions they hadn’t yet been awarded under the vesting schedule.
It’s common to see vesting schedules that grant a percentage of the amount contributed by an employer based on the amount of time they’ve been with the company. Understanding how vesting works can help employers and employees set expectations and make better decisions for business goals and employment duration.
How vesting works
Employer-sponsored retirement plans typically include a matching portion of an employee’s salary, usually around 3% to 6%. This amount is put into a retirement account, such as a 401(k), along with the employee’s contributions.
The employee’s own contributions are vested immediately, meaning they have complete ownership over the money they personally put into their own retirement account. But the employer’s contributions are often subject to a vesting schedule that gives the employee ownership of the employer’s contributions over time. There are three approaches employers take to vesting.
- Graded vesting schedule. This is the most common. Vesting occurs incrementally according to a predetermined schedule. There’s often an initial one-year period, or cliff, during which employees don’t become vested at all. (This makes sense, given that employees with less than one year of tenure at a company represent 22% of the market.) For each successive year, employees become increasingly vested. It’s common to see a four- or five-year vesting schedule. In a four-year graded vesting schedule, an employee will often vest at 25% at year one, 50% at year two, 75% at year three, and 100% at year four.
- Cliff vesting. With cliff vesting, employer match becomes vested all at once on a set date. For example, if an employer chooses a two-year cliff vesting schedule, the employer’s contributions will become 100% vested on the employees’ two-year work anniversary.
- Immediate vesting. Although less common, immediate vesting is also an option employers can select. Employees gain access to an employer’s contributions from the start.
As a fully vested employee, the employer’s contributions to the employee’s retirement accounts become nonforfeitable. The company can’t take them back for any reason.
An example of vesting
It’s typical to see an employer match 3% to 6% of an employee’s salary. Here’s an example of a four-year vesting schedule when 25% becomes vested each year. This example is what it looks like for the employee with a $50,000 salary and a 3% employer-contributed benefit. 3% would be $1,500 per year, or $125 per month.
This is for illustrative purposes for employer contributions and doesn’t take into account salary increases, market appreciation, or employee contributions.
After the four-year mark where this employee is fully vested, 100% of the employer contributions now belong to the employee.
Why do employers require vesting periods?
It’s common to see employers using a vesting schedule to give workers an incentive to stay. But it also may be required of businesses seeking venture capital.
To encourage employees to stay
In typical graded vesting periods, employees will own a greater percentage of an employer’s contributions in each successive year they are retained by the company. The longer they stay with the company, the greater the percentage of vested employer contributions they will have.
“The main reason employers set up vesting schedules is for employee retention,” says Bright Wealth certified financial planner Henry Hoang. “Hiring and training new employees is very expensive for businesses, so a vesting schedule allows a business to reward employees for their loyalty while minimizing financial risk should employees decide to quit before their benefits are fully vested.”
To seek venture capital
A vesting schedule is also essential for businesses seeking venture capital.
Michele Schueli, general partner and venture capitalist (VC) with a global portfolio of early and late-stage companies at Armyn Capital, says early-stage financial backers of companies often encourage the use of vesting schedules for stock options, usually four years with a one-year cliff for employees, or longer for company founders.
“Disregarding vesting is a problem for investors as it leads to a capitalization table filled with ‘dead equity,’ which is equity owned by founders/employees who left the company and are not adding any value,” Schueli, says. “Ultimately, ‘dead equity’ blocks result in a chaotic capitalization table, which makes it difficult for investors to fund the company, even if all other boxes have been ticked.”
The financial takeaway
When it comes to vesting, timing is critical for employees. If an employee knows that staying another two months means they gain access to thousands more in their retirement account, then they can plan their tenure at the company accordingly.
Businesses have different ways of vesting their employees, and it’s an often overlooked aspect of an applicant’s job search. It’s a good idea to understand how vesting works and what a potential employer is really offering in terms of compensation for the job — both now and for your future.