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What Are the Advantages of Cliff Vesting?

Dale Marshall
Dale Marshall

Cliff vesting — the practice of giving a person a full ownership interest in an asset all at once — carries benefits both for the grantor and the recipient of the assets. The concept is most commonly found in employee retirement and incentive programs, as well as in inheritance law. In all cases, though, it provides for the passage of time between the grant of an asset and the recipient’s full interest in that asset.

Most Americans are familiar with the concept of vesting as an element of the employer-sponsored retirement savings plans they belong to. Employees' ownership interest, or vesting, in their own contributions to the plan is entire and immediate. If the employer contributes to the plan, though, the employee usually doesn’t have full and immediate ownership rights over those contributions. Instead, she must wait a certain period of time before vesting takes place.

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Some plans vest incrementally, so that the employee’s interest increases over time, usually by 20% every year. Others employ cliff vesting – the employee has no interest at all for a certain period of time, after which she immediately has 100% ownership interest. The complete and immediately effective change might be compared to the sudden experience of falling off a cliff, hence the term.

The advantages to employers of cliff vesting in retirement programs are clear. Imposing a waiting period on full vesting provides the employee with an incentive to stay in the job. Another retention incentive takes over once the employee is vested; many employees, having gone through the waiting period to become vested, would prefer not to have to repeat the experience with another employer.

The alternative to cliff vesting, incremental or gradual vesting, generally starts earlier in a person’s employment. After a single year, for example, most plans call for 20% vesting. Thus, an employee could terminate the employment and leave with 20% of the employer’s contributions to the retirement savings plan. From the employer’s perspective, this could be seen as wasted money.

Vesting is also a feature of some employee incentive plans. Many employers grant stock options to their employees, but those options generally cannot be exercised immediately. Some employers provide incremental vesting in the options, so that after a certain period of time, the employee has a 20% interest and so on. Other employers grant 100% vesting after a certain period of time, traditionally a year after the initial grant. The better the employer does during that 12-month period, the more valuable the options and the greater the return to the employee.

Inheritance law also features cliff vesting as a way of protecting an estate and its heirs. Many wills bequeath money and goods to heirs and other beneficiaries, but often only to those who are still alive six months after the decedent’s death, which accomplishes two important goals. First, in the event of a disaster claiming the life of multiple members of a family, it avoids the problems associated with disputes over who died first. Second, it attempts to avoid inheritances passing from one to another and then a third person, as well as the potential tax consequences involved. Thus, a person may be named as the beneficiary of a will, but not vest in the inheritance until six months have passed, at which point vesting is complete.

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