Cliff Vesting

Article byNiti Gupta
Edited byPallabi Banerjee
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Cliff Vesting?

Cliff vesting is a specified 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.

Cliff Vesting

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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., an employee’s entitlement to the benefit plan will increase gradually over time. While in cliff vesting, employees will have to complete a specified period in the organization to become fully vested and receive the employer’s contribution in the benefit according to a pre-defined schedule.

Cliff Vesting Explained

The process of cliff vesting is a kind of vesting schedule that points out the time or the date before which the employee of an organization. is not entitled to the rights or the ownership of any contribution or benefit that the employer provides, which might be in the form of a stock option or retirement plan.  

After this period of cliff vesting schedule is complete, the employee gets full right to the above benefits or they become fully vested. Employers prefer it as they think of it as a way to retain employees in the organization at least for a specified period. They also use vesting to incentivize and retain hard-working or important employees.

It is different from the concept of incremental vesting, where the entitlement to the benefits provided by the employer accrues gradually over time in small amounts. Companies commonly use this process. in stock option schemes or retirement plans, and thus, the employee feels the need to stay with the organization. For a more extended period to access the benefits. If they leave the company before this period, they do not get the benefits. Thus, cliff vesting period works as a motivation and inspiration to stay on with the company and also work hard to continue in it.  

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Types

Cliff Vesting

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#1 – Time-Based

An employee’s entitlement to an employer’s benefit will increase gradually over time in a time-based schedule. Still, the employee will have to spend a specified time, say one year, in the organization to receive any benefit.

#2 – Milestone-Based

In a milestone-based cliff vesting 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 and 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.read more to receive an employer’s contribution to benefit plan.

Example

Let us understand the concept of cliff vesting accounting with the help of a suitable example.

An example of a cliff vesting schedule can be when an employee enters into five years cliff period contract for retirement benefits 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 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.read more where the employee becomes entitled to a share of the employer’s contribution since the starting of the plan, it becomes difficult for the employee and employer to end the working relationship if they are not satisfied with the current working conditions in fear of financial loss.

The positive aspect of cliff vesting period is that employers can retain hard-working employees through cliff vesting. Sometimes employers customize this schedule by shortening the cliff period to gain the trust of their employees.

Importance

Let us study the importance of the concept cliff vesting stock options or benefits in detail.

  1. Employers incentivize employees who add value to the organization through cliff vesting and help them become part-owners of the company.
  2. This embeds the environment of loyalty and reduces attrition in the organization.
  3. It also helps employers vet or understand the value of the employee before they become fully vested. Thus, the employer can understand and acknowledge the commitment of the employee towards the company and also unlock their full potential. 
  4. Hiring and keeping employees in an organization involves a certain amount of cost. This method helps in controlling the cost in the sense that since it is an excellent method of retaining employees, the cost of repeatedly hiring and training them for the requirements of the job is significantly reduced. Thus, a lot of cost is saved.
  5. Where the cliff period is attached to the completion of the business goal, it encourages the employee to perform better and helps the organization’s growth at the same time.
  6. The employees feel a sense of financial security. These benefits provide them with ways to keep their future safe. The retirement benefits are beneficial after the retirement of the employees, and methods like stock options give them the right of ownership to the company’s business, where they have a say in the decision-making process at various levels.

It is essential to understand the concept of cliff vesting stock options or benefits clearly because it helps in defining employee expectations. Also, the company plans with regard to retention plans and benefits, which influence the work culture and work dedication of employees. This also ensures sustainability and smooth working of the business without many problems related to employee satisfaction.

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.read more), 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.read more, 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 nothing less than the guidelines provided by the regulatory authority. Further, the minimum standard should always be met.

Cliff Vesting Vs Graded Vesting

Both the above are two separate methods that are related to employee ownership and benefit entitlement.

  • In cliff vesting accounting, employees must complete a designated period in the organization before becoming 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, they will receive no benefit.
  • 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.
  • From the above point, it can be derived that in the case of the former, there is no arrangement of payment or access to benefits based on proportionate completion of the job. But in the case of the latter, there is the arrangement of receiving benefits based on a percentage of time completed on the job.  
  • In the case of the former, there is a greater possibility for the employees to remain with the organization for a longer term because only they can ensure that they get access to the benefits. But the latter has less incentive for employees to remain on the job since they are sure to get at least a certain part of the benefits no matter when they leave.
  • The former involves more cost to the company because once the employee completes the vesting period, the company is obliged to give entitlement of the full benefits to them which involves some amount of expenditure from the company’s funds. But in the case of the latter, since the benefits are on a proportionate basis, the cost is not only distributed and does not become a big pressure at one particular point of time.

Thus, the above are some important differences between the two concepts, which should be interpreted in the correct manner so as to understand and implement them in the best way possible as per the company objectives.

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