What is vesting?
UPDATED: April 15, 2019
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The term vesting refers to whether or not the money that has been set aside for you in a retirement plan is yours to keep if your employment is terminated. Vested benefits are those to which you have an absolute right even if you resign or are terminated. Vesting is a term used in the Employee Retirement Income Security Act (ERISA). ERISA protects the rights of employees to receive certain promised benefits, including pension benefits and income from profit-sharing plans, once they have worked at a job for a certain period of time.
Once the employee has "vested" and the benefits are guaranteed under ERISA, the employee is entitled to the benefits as an absolute right, which means the employee must be provided with those benefits no matter what. This is true regardless of the employee's current status with the employer, so an employee may quit or be terminated and still be eligible for the vested benefits.
When Does an Employee Vest?
Employers covered under ERISA will typically include a vesting schedule in the summary of the retirement plan they provide to employees. The vesting period, or the time an employee can be required to work before the benefits vest, is often negotiated as part of a collective bargaining agreement or as part of pre-employment negotiations.
However, there are certain specified maximum time periods that covered employers may require employees to work before benefits vest. In some cases, such as when an employee puts money into a 401K, the money must vest immediately. This means employees are always guaranteed to receive the money they put into their 401K back when they leave the company.
In other cases, a longer maximum vesting period is permitted. For instance, employers may require up to five years of service for an employee to become 100 percent invested in a defined benefit plan. A defined benefit plan is one in which employees receive a set amount of benefits according to a formula that takes into account their salary history and time worked with the company. The five-year 100-percent vesting schedule that employers may use for this type of plan is referred to as cliff vesting.
Employers are also permitted to use a graduated vesting schedule for defined benefit plans instead of a cliff-vesting schedule. A graduated vesting schedule allows an employer to require up to seven years of service to become fully vested in the defined benefit plan. However, the employee must receive at least partial vesting at fixed intervals during the required seven-year period of service. For instance, after three years, the employee must be at least 20 percent vested and after four years, he or she must be at least 40 percent vested.
Employers also have a choice between cliff vesting and a graduated vesting plan for defined contribution plans. Defined contribution plans are those, such as a 401K, that do not promise a definite benefit but that instead provide a vehicle for investing and obtaining future benefits. The choice between cliff vesting and graduated vesting thus allows employers the opportunity to choose when their matched contributions to employee's 401K plans vest.
While vesting guarantees that an employee's promised benefits will be provided even when the employee leaves his or her position, it is important to note that defined contribution plans, such as a 401K , may experience a decline in value if the employee's investments do not perform as expected or lose value. This means an employee is not guaranteed to receive at least as much as he or she put into the 401K if the employee's investments within the account experience losses. Defined benefit plans, on the other hand, guarantee an employee will always receive the amount determined by the plan's formula. The employer in defined benefit plans bears the risk of losses to any pension investments or funds.
Other Meanings of Vesting
While the term vesting is most often associated with retirement plans, it has a legal meaning in other contexts as well. For instance, when an independent contractor is hired to produce creative work, it is important that the contractor first sign a work-for-hire employment agreement before any work is produced. The contract should give full rights for work produced to the employer in order to prevent the independent contractor from maintaining an ownership interest in the work produced. This is referred to as "vesting" the rights of ownership of the content in the hiring party.
The term vesting is also used to indicate the time period after which an employee gains control over his or her stock options provided by an employer. Until the options vest, the employee may not sell or transfer the stock or the options.
In addition, the term vesting is used in estate and inheritance law to indicate when a heir actually obtains full legal rights to his inheritance, in real estate to indicate when an owner takes title to a property, and in zoning law to indicate when someone has an absolute right to continue using a property as zoned at the time of construction or purchase.
The Definition of Vesting
In each of these examples, vesting indicates that a secured right is in place and cannot be taken away. This guarantee or granting of a secured right ultimately is the legal definition of vesting. The application of the term vesting, however, as seen in the different examples of vesting described above, differs depending on the context in which vesting is used.