When you set up your 401k plan, one of the most important components will be how your participants obtain ownership of employer contributions. Obviously, one of the biggest benefits of a 401k plan is the ability for both the employee and the employer to contribute together towards the employee’s retirement.
In an ideal world, your employees would work at your company for long periods of time. Reality, though, is that most employees change jobs several times during their career. In fact, it’s not unusual to see someone change jobs every few years.
Employee mobility creates an interesting question – when should they obtain full ownership of your contributions to their retirement plan? You can manage this issue through vesting, which should be spelled out in your plan document.
Vesting is a powerful tool to attract and retain employees. There are many different ways to set up your company’s vesting schedule. Here are three of the most common:
An immediate vesting schedule is exactly what it sounds like. As soon as you make a contribution to an employee’s retirement plan, they own 100 percent of that contribution, regardless of how long they’ve worked at the company.
Immediate vesting can be a powerful way to attract new employees. Most companies don’t do immediate vesting, so you will definitely stick out if you adopt an immediate schedule. If you want to be aggressive in recruiting the best talent, this could be the way to go.
Of course, the risk is that you could have employees leave after only a year or two. If they do, they’ll get to take all of your contributions with them. If turnover is common at your company, immediate vesting may not be the best solution.
With cliff vesting, your employees become 100 percent vested at a certain point in the future, such as one or two years after joining your company. By law, the longest period you can have under a cliff schedule is three years.
As an example, an employee joins your company and receives matching contributions for the first three years. If they leave during that period, they can take their contributions, but they do not get to take your contributions. After the three-year point, they get to take all contributions.
The benefit to this is that it encourages your employees to stay with your company for a longer period of time. However, some employees may be turned off by the idea that they get zero vesting during the first few years.
Graded vesting offers the best of both worlds in that it allows some vesting immediately, but also encourages employees to stay with your company. In a graded schedule, a portion of the employer contributions becomes vested each year.
A common graded schedule is for 20 percent of contributions to become vested each year. So, after year one, the employee takes ownership of 20 percent of employer contributions. After year two, they own 40 percent. This continues until the end of the fifth year, when they become 100 percent vested.
Again, this kind of schedule gives employees incentive to stick around. It also may be perceived by employees as being more fair than a straight cliff schedule.
One important consideration is that you can change your vesting schedule but not in a way that harms employees. For example, if you have a five-year graded schedule, you can’t switch to a six-year. If you have a two-year cliff, you can’t switch to a three year. So if you choose immediate vesting, you are likely stuck with that option permanently.
For more information on how to structure your plan, contact one of our 401k consultants. We would be happy to review your plan and offer insights on how you can make it stronger for your company and your employees.