What is cliff vesting?
Cliff vesting 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, the employee obtains the absolute right to his benefits over time. For instance, an employee might become 20 percent vested after one year; 50 percent vested after two years and 100 percent vested after three years. With cliff vesting, an employee who leaves the company before the designated vesting time will leave with no portion of the employer-provided retirement benefits at all.
The Employee Retirement Income Security Act (ERISA) protects the rights of employees to receive pension benefits that they are promised by their employers. Although employers aren't required to offer pension plans, employers are required to pay as promised once a pension plan program has been established. Pension plans covered under ERISA have a certain time period when they vest and once an employee's benefits have vested, the employee has an absolute right to receive the benefits regardless of whether he is terminated or leaves his job.
What Is Vesting?
Employers who offer pension plans 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 benefit 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, and employers may guarantee that they will match a portion of the employee's investment. There is not any guarantee of exactly what benefits the employee will receive, since this will, in part, depend on how wisely the employee invests the money in the defined contribution plan.
With either a defined benefit or a defined contribution plan, a worker's right to receive the promised pension benefits is guaranteed after some point. 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.
In some cases, vesting is immediate. For instance, when an employee puts his own money into a 401K, he is automatically vested and can take that money out at any time regardless of whether he leaves the company or continues working there. The employer's contribution 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 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 or graduated vesting.
Understanding 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 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 a three-year cliff vesting schedule for designated defined-contribution plans including 401Ks. This means that an employer can generally require an employee 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 account. Alternatively, he may simply retain the rights to his benefits and begin collecting them when he reaches retirement age.