Vesting is a legal concept where a person gains legal ownership of a certain type of property after a specific period, known as the vesting period. Once vested, the individual has an irrevocable right to this asset, regardless of whether they physically possess it yet.
Contexts of Vesting in Business
In the realms of business ownership or human resource management, vesting typically appears in two scenarios: employee retirement planning and employee equity.
Vesting Schedule and Period
A vesting schedule or period is the duration an employee must work for a company before they can own company-provided assets like employee stock options, company shares, or access employer contributions to a retirement plan such as a 401(k). Vesting periods for retirement plans have regulatory limits set by the U.S. government, while those for stock options or shares are usually agreed upon in the initial employment contract.
What is 401(k) Vesting?
A 401(k) is a retirement plan sponsored by U.S. employers. Employees can opt to have a portion of their paycheck deposited into this plan, with employers potentially matching part of these contributions.
Ownership of Retirement Assets
The vesting schedule dictates when an employee fully owns the retirement assets. While the employee's own contributions are immediately theirs, the employer-matched funds require vesting. After the vesting period, typically three to four years, the employee becomes fully vested, gaining complete rights to both their contributions and the employer's.
Vested Balance in 401(k)
The vested balance in a 401(k) refers to the amount the employee currently owns, including both their contributions and the vested employer contributions. This amount is accessible upon leaving the job or withdrawing from the fund.
Non-Vested 401(k) Funds
For non-vested funds in a 401(k), employees have no rights. This means that unvested employer contributions can be forfeited if the employee leaves the company before the end of the vesting period.
Stock vesting applies to employee stock options or company shares, where employees don't immediately receive these assets. Instead, they earn the right to buy shares at a predetermined price in the future, or receive actual shares that can be sold later, subject to the vesting schedule.
Types of Vesting Schedules for Equity
Equity vesting can be time-based, requiring employees to stay with the company for a specified duration, or milestone-based, linked to achieving specific goals or company milestones like an IPO. Time-based arrangements often include a one-year cliff, followed by gradual vesting over time.
Purpose of Vesting
Companies introduce vesting schedules to reduce turnover, thereby saving on recruitment and training costs. These schedules allow businesses to offer benefits like retirement matching and equity without the risk of losing investment in employees who may not remain with the company long-term
Example of 401(k) Vesting
Imagine an employee, Sarah, joins a company that offers a 401(k) plan with a matching contribution and a vesting schedule of four years. Sarah decides to contribute 5% of her salary to her 401(k), and her employer matches this contribution 100%. However, according to the vesting schedule, Sarah will only gain full ownership of her employer’s contributions after four years of service.
Year 1: Sarah contributes to her 401(k), but if she leaves the company at this point, she only takes her contributions. The employer's matched contributions are not yet vested.
Year 4: Sarah is now fully vested. She owns 100% of both her contributions and her employer's matched contributions. If she decides to leave the company now, she can take the total amount in her 401(k), including the employer's contributions.
Example of Stock Vesting
John is hired by a tech company and as part of his compensation, he is granted 1,000 stock options with a four-year vesting schedule and a one-year cliff. This means:
Before Year 1: If John leaves the company before completing one year, he forfeits all his stock options.
End of Year 1: The one-year cliff is reached, and 25% of his options (250 shares) vest. John now has the right to exercise these options.
End of Year 4: John remains with the company for four years and is now fully vested. He has the right to exercise all 1,000 stock options.
In both examples, the vesting schedules serve as an incentive for Sarah and John to remain with their respective companies, allowing them to fully benefit from the retirement plan and stock options provided.