What is Cliff Vesting?
Cliff vesting is a specified point of time or date when the employee becomes fully vested i.e. gains the right to receive full benefit from a retirement plan, provided by the employers. It is different from normal vesting because normal vesting happens incrementally over time, while in cliff vesting employee becomes fully vested at a specified date.Vesting is the legal term for having full entitlement or legal rights over benefits provided by employers.
In most cases, vesting increases gradually over time, i.e., employee’s entitlement to the share of benefit plan will increase gradually over the period of time. While in cliff vesting, employees will have to complete a specified period of time in the organization to become fully vested and then will receive the employer’s contribution in the benefit according to a pre-defined schedule.
It is preferred by employers as they think it as a way to retain employees in the organization at least for a specified period of time. They also use this type of vesting to incentivize and retain hard-working or important employees.
Types of Cliff Vesting Options
#1 – Time-Based
In a time-based schedule, employee’s entitlement to an employer’s benefit will increase gradually over time, but the employee will have to spend a specified time say one year in the organization to receive any benefit at all.
#2 – Milestone-Based
In a milestone-based schedule, employees are asked to achieve a specific business goal or complete a project, after which they become entitled to receive full benefits from the employer benefit plan.
#3 – Hybrid or Mix-Off
In a Hybrid or mix off vesting schedule, the employee will have to complete a specified period of time as well as achieve a business goal or milestone to become fully vestedFully VestedFully vested refers to a situation where an investor enjoys full authority and control of every financial instrument (stock options, retirement benefits, profit sharing). It is often followed by a vesting schedule. It is a verified right to the investor and can't be removed from an outsider. to receive an employer’s contribution to benefit plan.
Example of Cliff Vesting
An example of a cliff vesting schedule can be when an employee enters in 5 years cliff period contract for retirement benefit with the employer. This means that the employee will become fully vested i.e., he will be entitled to receive 100 percent of the employer’s contribution to the benefit plan after the completion of 5 years. And if the employee leaves before this period, he will only be entitled to receive their own contribution (if any). Employees will not receive any portion of the employer’s contribution to the benefit plan if the employee leaves before the completion of the cliff period of 5 years.
Reasons to Consider Using Cliff Vesting
In regular vestingVestingShares vesting refers to the grant of shares over a pre-decided tenure as the compensation package or contribution towards the pension scheme to the employees or to the founders of the company to reward them for their work performance and to retain them for longer years in the company. where the employee becomes entitled to the share of employer’s contribution since the starting of the plan, it becomes difficult for the employee as well employer to end the working relationship if they are not satisfied with the current working conditions in fear of financial loss.
The positive aspect is that through cliff vesting, employers can retain hard-working employees. Sometimes employers customize this schedule by shortening the cliff period to gain the trust of its employees.
- Employers incentivize employees who add value to the organization through cliff vesting and help them become part-owner of the company.
- This embeds the environment of loyalty and reduces attrition in the organization.
- It also helps employers to vet or understand the value of the employee before they become fully vested.
- Where the cliff period is attached to the completion of the business goal, it encourages the employee to perform better as well as helps in the growth of the organization at the same time.
Cliff Vesting vs. Graded Vesting
In cliff vesting, employees have to complete a designated time period in the organization before they can become fully vested to receive the employer’s contribution to the benefit plan. And if the employee leaves even before a week of the designated time, he or she will receive no benefit at all.
Whereas in graded vesting, the employee will receive a certain percentage of the employer’s contribution to the benefit plan at the end of each year. For example, in 5 years graded vesting schedule, employees will receive 20 percent of the employer’s part each year, and after five years, employees will become fully vested.
Company Benefits and Cliff Vesting
Companies provide various kinds of benefits to their employees, like retirement plans (defined benefit and defined contribution plansDefined Contribution PlansA defined contribution pension plan is when the employer and the employee frequently make a significant amount of contributions to enable employees to save a decent amount of money for the retirement period and leave with the utmost dignity in their retirement phase.), stock optionsStock OptionsStock options are derivative instruments that give the holder the right to buy or sell any stock at a predetermined price regardless of the prevailing market prices. It typically consists of four components: the strike price, the expiry date, the lot size, and the share premium., profit-sharing plans, and so on. Companies should adhere to minimum vesting standards provided by the regulatory authority of the related jurisdiction.
Though companies are not restricted to put variation in the various benefits plan provided to employees, they are required to maintain a plan which is no less favorable than the guidelines provided by the regulatory authority. Further, the minimum standard should always be met.
This has been a guide to what is cliff vesting. Here we discuss an example and three types (Time-Based, Milestone-Based, and Hybrid) of cliff vesting along with their importance and differences. You can learn more about financing from the following articles –