By now you probably understand how cash balance plans work. But how much do you know about cash balance plan vesting schedules?
Vesting is often overlooked when it comes to plan design. The good news is that you have a couple options.
In this post, we will address these items and try to clarify what vesting really means. Let’s jump in!
What does vesting mean?
Let’s assume that you are self-employed and you have 6 employees. Let’s also assume that 3 employees were ineligible or otherwise excluded from the plan. So, you ended up making a contribution for yourself and also for the 3 remaining employees.
So now that the contribution has been made you understand that there is a vesting requirement. This requirement is for you and the 3 employees. But explaining the rules to the employees can be a little challenging.
Even though employees were allocated a contribution, they really don’t have the right to the funds yet. They really don’t “own” the funds.
Vesting, in it’s simplest form, means ownership. Each employee will then vest (or own) a specific percentage of his or her retirement account in the cash balance plan each year.
If employees are 100% vested that means they owns 100% of the account and the employer is not able to take it back from the employees. Any amount that is not vested can be forfeited and allocated back to the company to reduce future contributions.
For example, let’s assume an employee has a $10,000 balance and is 60% vested. If the employee leaves the company, they would get $6,000 and the remaining $4,000 reverts back to the plan.
Vesting rules and requirements
The main purpose of vesting from an employer standpoint is to give employees an incentive to stay with the company. The benefits of this are twofold: employers will have higher retention and employees are financially rewarded for staying with the company. It is sort of like a bonus and many employers treat it as such.
If an employee contributes their own money (like a 401k employee deferral), then that money is always 100% vested to the employee. It was their own money they contributed. So that makes sense.
But cash balance plans and other defined benefit plans are funded solely by the company. If the company wants, it can vest 100% of the contribution up front. But this does not typically meet the goals of the employer. So, they can have a vesting schedule so employees will have an incentive to stick around.
But they can’t pick any vesting schedule they want. The IRS has spelled out rules and requirements and minimum vesting standards so that a company must vest to employees based on a reasonable time frame.
There are basically three types of vesting schedules that employers can use to allow employees full ownership of any employer contributions.
Immediate vesting on contribution date. Just like it sounds, employees with this vesting schedule get 100% vested in the employer contribution once it is contributed to the account.
Graded schedules. This type of vesting plan gives employees ownership gradually over time as their company service increases. At some point, the employee has 100% ownership. Like the prior example, if the employee leaves before the completed service period, he or she can only keep the percentage in which they were vested. The federal government has established a six-year maximum on any graded vesting schedules.
Cliff schedules that are “all or nothing”. This type of vesting confers 100% employee ownership all at one date in the future. For example, this could be one year or three years. But if the employee does not stay with the company until hitting that date, he or she gets nothing. The contributions are then forfeited and will go back to the company to reduce future contributions. Just like graded vesting, the federal government establishes rules and requirements. As such, cliff vesting cannot exceed three years by law.
Most cash balance plans are set up using three-year “cliff” vesting. In this case, the employee is 0% vested until they complete three years of employment, at which point the employee is 100% vested.
Defined benefit plan vesting requirements
A traditional defined benefit plan must have a vesting schedule as least as generous as one of the following:
- 5-year cliff – participants are 100% vested upon being credited with 5 years of service, or
- 7-year graded – participants vest 20% per year beginning with being credited with 3 years of service, becoming 100% vested with 7 years of service.
Cash balance plan vesting schedule
However, a cash balance plan must vest benefits as least as generous as a 3-year cliff vesting schedule.
If a defined benefit plan is top-heavy, in addition to minimum accrued benefits (unless top-heavy benefits are provided in a defined contribution plan), the vesting schedule must be at least as generous as one of the following:
- 3-year cliff – participants are 100% vested upon being credited with 3 years of service, or
- 6-year graded – participants vest 20% per year beginning with being credited with 2 years of service, becoming 100% vested with 6 years of service.
|Graded Vesting ✅
|Cliff Vesting ✅
|Allows for pro-rata vesting
|Full vesting at end of term
|One of two approved approaches
|No vesting prior to final date
|Common for profit sharing plans
|Typical with cash balance plans
|Great for retention
|“All or nothing” structure
How does a cash balance plan vesting schedule work?
- The vesting percentages and schedule is spelled out in the plan document. The company will decide up front whether a plan will be vested immediately or over a certain period of time.
- Employees are notified of vesting requirements. Employees will be told by the company the vesting percentages and the applicable dates.
- Employees receive ownership on vesting date. The third-party administrator will calculate and track the vesting for each employee and distribute employee reporting to the company.
- Annual reporting. The annual valuation report should be completed annually by the administrator.
- Coordinate amendments. Should the employer decide to amend the vesting this can be done on a prospective basis without impacting current vesting.
So there you have it: the complete guide to cash balance plan vesting schedules. Hopefully, it was not as challenging as you thought.
But it is important to realize that as the business owner you have vesting options. Make sure you discuss this upfront with your plan administrator.