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Cliff vesting is a type of vesting schedule associated with retirement plans such as 401(k), 457, and 403(b) plans. The term vesting is used to define the percentage of an account balance that a participant in a retirement plan is entitled to.
Employers who sponsor a retirement plan often tie employer contributions to a vesting schedule. The reason for this is to entice participants to stay with the employer for a set number of years in order to be fully vested, or entitled, to those employer contributions. In this manner, the use of a vesting schedule may increase employee retention.
The vesting schedule will assign a percentage based on years of service the employee completes. Some vesting schedules are based on a graded schedule where the employee receives, say, 20% vesting for each year. Such a schedule would mean the employee is 100%, or fully vested in the plan after five years of service.
The cliff vesting schedule is not a graded schedule. It usually does not give the employee any vesting percentage until after the completion of a specified number of years of service. The number of years could be at a minimum one and no more than five. When the target number is reached, the employee is 100% vested. It is referred to as a cliff vesting schedule because of the jump to 100%. For example, a 3-year cliff vesting schedule means the employee is zero percent vested after years one and two, and then 100% when the schedule reaches the cliff after year three.
There are a few reasons why a cliff vesting schedule may help with employee retention. An employee who terminates employment before becoming fully vested will lose out on all of the non-vested money in his or her account. The loss is especially obvious because in most plans employees have daily access to see the their entire account balance. Additionally, after achieving fully vested status, employees do not want to start over with a new vesting schedule in another company’s plan.
An important aspect of the cliff vesting schedule that plan sponsors have to be aware of is that it must meet certain statutory requirements. Primarily that in no cases does it require more than five years of service to be fully vested. Furthermore, for 401(k) plans, the maximum number is three years.
Another requirement is that in the event an employee reaches normal retirement age as defined by the retirement plan, the employee must become fully vested. However, the employee would still need to be employed on that date.
In no case can a vesting requirement of any type be placed on employee contributions. Any money that an employee contributes from his or her paycheck is essentially immediately fully vested. The same rule applies for any money that an employee rolls into the plan.