What is cliff vesting?

Cliff vesting is an employee benefit plan that means an employee becomes 100 percent vested (and entitled to the full amount of promised pension benefits) all at once. When an employer offers graduated vesting options, the employee obtains the absolute right to his benefits over time according to specific term schedules.

For instance, on a four-year vesting period, an employee might become 20 percent vested after one year; 50 percent vested after two years and 100 percent vested after four years.

With cliff vesting, an employee who leaves the company before the designated vesting time requirement will leave with no portion of the employer-provided retirement benefits payout at all. On a one-year cliff, an employee would be fully vested after just one year. This is one reason employers favor cliff vesting. It requires a certain commitment from the employee.

The Employee Retirement Income Security Act (ERISA) protects the rights of employees to receive pension benefits promised by their employers. Although employers aren’t required to offer a pension or qualified retirement plan, employers are required to pay as promised once a pension plan program and cliff period for vesting have been established.

Pension plans covered under ERISA have a certain time period before vesting and once the employee benefits have vested, the employee has an absolute right to receive the vested benefits regardless of whether he is terminated or leaves his job.

What Is Vesting for Eligible Employees?

Employers who offer pension plans as part of an employee benefits compensation package may offer either a defined benefits or a defined contribution plan. A defined benefits plan means that an employee will be entitled to a certain amount of money or other compensation from the employer that is guaranteed.

When a defined contribution plan is offered, on the other hand, employees can invest a certain amount of their own money. Employers may guarantee that they will offer matching contributions or match a portion of the employee’s investment amounts.

There is not any guarantee of exactly what range of benefits the employee will receive. This will, in part, depend on how wisely the employee invests the money in the defined contribution plan. Will the employee invest set amounts over time, or do they plan to make adjustments along the way?

With either a defined benefit or a defined contribution plan, a worker’s right to receive the promised pension benefits is guaranteed after vesting.

For a defined benefits plan, this means that the employee will be guaranteed the promised benefit amount. For a defined contribution plan, this means the employee can take out whatever money is in the investment account, including money contributed by employer matching.

The time period when this guarantee of benefits to the worker goes into effect is called vesting.

Some types of vesting are immediate. For instance, when an employee puts his own money into a 401K, he is automatically vested and can take 100 percent of that money out at any time regardless of whether he leaves the company or continues working there.

The employer contributions to the 401K, on the other hand, may not vest immediately. There may be a requirement that the employee must work with the company for at least a year (or some other designated period of time) before his right to matched contributions is guaranteed.

Likewise, with a defined contribution plan, there is almost always a time limit before an employee vests and is guaranteed retirement benefits.

Maximum time limits are in place for the length of time an employee must work before his employer needs to vest his pension. These time limits change depending on whether an employer offers cliff vesting options or graduated vesting.

Why Do Some Employers Offer Cliff Vesting?

Cliff vesting is often favored by employers who believe it will help to ensure employees remain with the company to reach their cliff date. However, employers cannot simply set the vesting period schedules far off into the future. They must comply with maximum vesting time limits for cliff vesting.

In most cases, when cliff vesting is used, an employee must be 100 percent vested within five years of starting work. However, the Pension Protection Act of 2006 mandated minimum vesting standards of a three-year cliff vesting schedule for designated defined-contribution plans including 401Ks.

This means that an employer can generally require an employee to work for five years before benefits vest; unless the pension plan offered is a designated defined contribution plan such as a 401K in which case the employer can only require the employee to work three years before vesting.

Once an employee is vested, he is guaranteed to receive the promised pension benefits. When the employee leaves the company, he may roll the benefits into a new 401K or take other appropriate action depending on the type of plan. Alternatively, he may simply retain the rights to his benefits and begin collecting them when he reaches retirement age.