When it comes to running the company 401(k), there are a lot of trade-offs to consider. For example, you want to offer employees ample investment options so that they can construct a diversified portfolio that suits their risk profile, yet too many investment options can overwhelm employees and paralyze them into inaction.
Or consider that one way to encourage participation (and to get your employees saving for retirement!) is to offer an employer match. On the one hand, matching employee contributions consumes company cash flow. And on the other hand, widespread employee participation is critical to passing the annual nondiscrimination tests.
Your plan’s vesting schedule provides another way to tailor employee benefits to produce the combination of incentives and rewards that best fit your business.
What is vesting?
“Vesting” is the term used to describe how employees gain complete ownership of their 401(k) benefits. To clarify, any contribution an employee makes to the plan belongs to that employee immediately. Employee contributions remain with participants even when they leave the company.
Vesting is the act of employees gaining ownership of contributions made by the employer. The vesting schedule describes when ownership becomes effective. For example, a vesting schedule could look like this:
Percentage ownership of employer contributions by tenure
**Years of Service****Graded Vesting**1 0% 2 20% 3 40% 4 60% 5 80% 6 100%
According to the above schedule, if an employee leaves after two years of service– a year of service is defined as one in which an employee has worked at least 1,000 hours–that employee is entitled to all employee contributions, but only 20% of any employer contributions. The amount the employee owns includes associated investment earnings.
The table is an example of “graded vesting.” That means participants accrue more ownership of company contributions the longer they are employed. But there are two other options when it comes to 401(k) vesting: immediate and “cliff” vesting. Immediate vesting means just that – once an employee joins the plan, the new participant owns 100% of any employer contributions.
Under a cliff vesting arrangement, employees are not entitled to any employer contributions until they have worked for the defined years of service. But employees are entitled to 100% of employer contributions once they reach the defined tenure.
For example, a new 401(k) participant might not “own” any employer contributions until they have completed three years of service. From that day forward they are entitled to all employer contributions. An example of a cliff vesting schedule is presented below:
Percentage ownership of employer contributions by tenure
**Years of Service****Cliff Vesting**1 0% 2 0% 3 0% 4 100% 5 100% 6 100%
Eligibility and vesting
Be sure not to confuse eligibility and vesting. Eligibility refers to when new employees can join the plan. Some companies require that employees work a certain number of hours before they can join the 401(k). Strict eligibility requirements were more important back when it was a costly hassle to add an employee to the retirement plan. (If that’s still the case at your company, you need to consider hiring a new provider!)
What vesting schedule is best for your 401(k)?
A number of factors come into play when designing your plan’s vesting schedule. Of course the key factor is what is required by law. ERISA rules require that graded vesting take no longer than six years or service. Cliff vesting is limited to three years of service. Within those guidelines, your company is free to design a schedule that works for you and your company. For example, a typical five-year graded schedule may work just fine for one company, but it may actually discourage participation in the plan at another. In fact, a graded vesting schedule could even discourage new hires. Consider that the Department of Labor calculates that the average employee tenure today is just over four years. That’s shorter than the maximum schedule allowed for graded vesting!
If you are competing heavily for workers, you may want to consider your employer contribution as a hiring incentive and your vesting schedule as an incentive to remain with the company. A relatively higher employer match might be your recruiting tool, and a three year cliff vesting schedule might encourage those skilled workers to stay with your company. Three year cliff vesting might also be a good fit if most of your employee turnover occurs in their first two years of employment.
A Word on Safe Harbor plans
Vesting decisions can be less of a concern with Safe Harbor 401(k)s. A Safe Harbor structure requires a minimum level of employer contributions in exchange for exemption from certain nondiscrimination testing.
Another requirement under the Safe Harbor structure is that participants are immediately 100% invested in employer Safe Harbor contributions. The decision to undertake a Safe Harbor approach can be driven by the desire to maximize tax deferrals for highly compensated employees without the worries of correcting for failed test results.
What’s typical when it comes to vesting?
It’s become fairly common for employers to offer employees immediate vesting. According to a 2016 study, 47% of plans where Vanguard served as recordkeeper offered immediate vesting. Vanguard’s small business clients were even more likely to vest immediately, with 66% of plans making employer matching contributions immediately available to eligible participants.
But what makes sense for some companies may not be in your plan’s best interest. At ForUsAll we examine all the fine details of your plan’s design, including helping you determine the right vesting schedule for your circumstances. If you have questions about 401(k) vesting or anything else related to plan administration, don’t hesitate to get in touch! We’re always happy to help.