Cliff vesting schedule

What is a cliff vesting schedule in defined contribution plans?

A cliff vesting schedule is a type of plan used by employers in which employees gain full rights to their employer’s contributions to defined contribution plans, such as 401(k) and 403(b)  retirement plans, at the end of a vesting computation period, rather than gradually earning these rights over an extended period. 

How cliff vesting works

Cliff vesting differs from other vesting schedules by requiring employees to wait until a specific period to become fully vested in employer contributions. 

The point when employees become fully vested typically marks a "cliff" because, before this point, the employee has no claim to the employer’s contributions if they leave the company. Unlike gradual vesting, employees under a cliff vesting schedule receive 0% of benefits until they reach the designated period, at which point they become 100% vested.

Three-year maximum

In defined contribution plans like 401(k) and 403(b) plans, the maximum period for cliff vesting is three years. This means employees are 100% vested in employer contributions after completing three years of service. If they leave the company before reaching three years, they forfeit all their employer-contributed benefits.

Flexibility in vesting period

While the maximum cliff vesting period for defined contribution plans is three years, employers can choose to offer a shorter vesting period. For example, a 401(k) employer can offer full vesting after one year if they prefer. The three-year period is a maximum limit, not a requirement.

Pros and cons of 401(k) cliff vesting schedules

Employee retention

Cliff vesting schedules are an effective strategic tool for retaining talent. Since employees know that they will forfeit their benefits if they leave before the vesting period is up, they are generally more motivated to stay with the company longer. This reduces turnover and helps build a stable and experienced workforce.

Cost efficiency

Employers benefit financially from cliff vesting plans, as these schedules prevent the company from paying significant benefits to employees who do not stay long enough to reach the vesting period. This can help in managing the costs associated with employee benefits more effectively, as forfeitures from employees who leave before the cliff vesting date can be used to offset future employer contributions and plan costs.

Performance incentives

Cliff vesting can serve as a motivational tool that aligns employee interests with the objectives of the company. By designing these schedules in terms of timing and goals, companies can significantly enhance workforce stability, reduce costs, and drive performance.  

One of the main benefits of a cliff vesting schedule for employees is the potential to receive significant equity or retirement contributions after staying with a company for a predetermined period. This kind of vesting schedule can be particularly appealing as it often involves a substantial lump-sum benefit that becomes available after the vesting period, serving as an incentive for employees to remain with the company long-term

“All or nothing” risks

However, cliff vesting schedules also come with notable risks and disadvantages. If an employee leaves the company or is terminated before the vesting period is complete, they lose all the benefits that would have been vested at the cliff date. This "all-or-nothing" approach can be particularly risky in volatile job markets or industries prone to frequent layoffs. 

While cliff vesting schedules provide valuable opportunities for securing employee loyalty and engagement, they require careful thought and strategic planning to maximize their benefits and minimize any potential drawbacks. Check out our Learning Center article for information on how employers can manage their 401(k) vesting schedules.