Vesting measures the non-forfeitable interest a participant has in the employer portion of his/her account balance. An employee is always fully vested in his/her own contributions. Employer contributions that are not fully vested in the employee are forfeited upon termination of service and payment of the vested account balance to the former participant. Such forfeitures are allocated to the remaining participants, used to reduce employer contributions or, less frequently, pay 401(k) plan expenses.
The emphasis placed by the employer on attracting new employees versus retaining existing ones affects whether a vesting schedule should be adopted (or whether full and immediate vesting is selected) and which one is chosen. Full and immediate vesting may be advisable for some employers. This increases employee appreciation of the plan for new employees; it also prevents resentment from existing employees not being entitled to employer contributions to be made on their behalf. In addition, using a vesting schedule requires that the vesting percentage that applies to each employee's account balance be calculated, at least annually. This is a time-consuming process and one that is prone to errors in calculation. However, if employee turnover is high, using a vesting schedule may significantly lessen employer contributions. A vesting schedule may also, to some extent, reduce employee turnover. When deciding whether to choose a vesting schedule or full and immediate vesting, all relevant factors should be considered. A design expert can help make any calculations that are needed in this analysis. Some basic considerations that should be addressed when designing the vesting feature are the following:
a. For "top-heavy plans" (those in which the value of the accounts of the "key employees" are greater than 60% of the value of the accounts of all employees), a vesting schedule that is at least as liberal as one that provides 100% vesting after 3 years of service or a 6-year graded vesting schedule (increasing 20% a year and beginning in the second year) must, by law, be chosen.
b. For non top-heavy plans, the vesting requirements for employer matching contributions are the same as those for top-heavy plans. However, for profit sharing contributions (which may or may not be part of a 401(k) plan), a vesting schedule at least as liberal as one that provides 100% vesting after 5 years of service ("cliff vesting") or a 7-year graded vesting schedule (increasing 20% a year and beginning in the third year) must, by law, be chosen.
c. Some years of service may be excluded when calculating years of service credited for vesting purposes. Employment before age 18 and prior to the establishment of a plan (or predecessor plan) may be excluded. Although most 401(k) plans do not contain these exclusions, they are available.
d. 100% vesting is required when a participant attains Normal or Early Retirement Age. The plan may choose a Normal Retirement Age of 65 and 5 years of plan participation. This enables employers to hire older employees and not vest them fully until they have been employed for at least 5 years.
e. 100% vesting on death and/or disability is frequently selected, although there are no legal requirements for more rapid vesting for these events. Various definitions of disability may be used in this regard, including the one used for social security purposes or that contained in the employer's long term disability plan. The costs of providing 100% vesting on these additional benefits are generally very small.