Katie Adams is a marketing and public relations professional, as well as a freelance commercial writer with 17+ years of experience.
Updated February 22, 2024 Reviewed by Reviewed by Marguerita ChengMarguerita is a Certified Financial Planner (CFP), Chartered Retirement Planning Counselor (CRPC), Retirement Income Certified Professional (RICP), and a Chartered Socially Responsible Investing Counselor (CSRIC). She has been working in the financial planning industry for over 20 years and spends her days helping her clients gain clarity, confidence, and control over their financial lives.
Cliff vesting occurs when an employee becomes fully vested in an employer-sponsored savings plan on a specified date rather than becoming partially vested over an extended period. Cliff vesting applies to plans like employer-sponsored retirement or stock option plans. An employee is considered vested in an employer-sponsored retirement plan or employee stock option plan once they have earned the right to receive benefits from that plan.
Employers choose to provide various benefits to employees in return for their loyalty and service and to attract and retain them. Those benefits include pensions and retirement plans, such as a 401(k) or a 403(b), and assets like equity or stock.
Companies often give their employees equity as part of their overall compensation package. Equity represents partial ownership of the company, and offering ownership is a way to incentivize employees—to encourage them to stay and to perform well. However, a company is unlikely to give an employee stock until they have earned it. And that takes time.
As noted above, cliff vesting refers to the process where employees become fully vested in their plan by a specific date. Plans often have a four-year vesting schedule plan with a one-year cliff. After one year of service under this type of vesting for stock options, an employee would get 25% of their shares vested. They would get another 1/48th of their shares vested every month that they stay with the company after that point. After four years, they would be fully vested.
One thing to keep in mind is that vesting periods depend on and are set up by employers. This means that cliff vesting may or may not apply to all companies or all types of plans. Other plans might release benefit amounts over another scheduled period.
While any vesting plan must meet minimum standards set by the Internal Revenue Service (IRS), most employers will require the employee to demonstrate commitment over a period before the employer will support the employee with financial benefits in the form of vesting.
Vesting schedules can be time-based, milestone-based, or a mix of time-based and milestone-based.
Many managers see the benefit of cliff vesting as rewarding only those employees who are worth a company's investment. Employees who are committed to the company will stick it out and reap the benefits of their employer-sponsored plans. If the cliff vesting period is short, it may seem attractive to a new employee who otherwise might have to wait longer to be fully vested in a benefit plan.
Costs are another key benefit. Companies want to invest in long-term employees. As such, they aren't required to pay full benefits to employees who decide to leave before they reach the vesting period, which cuts down their expenses.
But cliff vesting can also seem like a risky proposition to an employee. The contract or arrangement could terminate for some reason just before the initial qualifying period is complete. For example, there may be a hostile takeover of the company or a buyout whereby new policies nullify the cliff. Or the company could be a startup that fails before the vesting date.
Managers at start-ups have been dismayed when employees who have the typical four-year-plus-one-year cliff vesting plan leave the company soon after the one-year cliff with 25% of their shares vested.
Here's a hypothetical example to show how cliff vesting works. Let's assume that an employee is fully vested in a pension plan after five years of full-time service. Partial vesting would occur if the employee were considered:
If an employee leaves the company before becoming fully vested in a cliff vesting pension plan, they would not receive any retirement benefits.
A cliff is a time period that has to pass before an employee's benefit plan can vest. If a cliff vesting period is three years, the employee won't be vested until those three years are up, at which point they will be fully vested.
This type of cliff vesting arrangement means that after one year of service an employee would get 25% of their shares vested. Thereafter, another 1/48th of their shares would be vested every month that they stayed with the company. After four years they would be fully vested.
Cliff vesting involves vesting that happens all at once on a specified date, such as after five years of service. Graded, or gradual vesting, occurs incrementally over time. For example, if the vesting period is 10 years, an employee might be 20% vested after two years, 30% after three years, and 100% after 10 years.
When you are thinking of joining a company, it's important to understand the benefits it offers and when you will be vested in certain of those benefits. For example, if there is a company 401(k) retirement plan, 100% vesting may be immediate, or bestowed after three years of service, say, or on a gradual schedule that increases your vested percentage for every year of employment with that firm. Note, however, that an employee's contributions to a company retirement plan are always 100% vested, or owned, by that worker.