Are vesting schedules still effective?
Vesting schedules have traditionally been used by employers to manage retirement plan costs while encouraging employee loyalty. But new research shows they may not be as effective at retaining employees as once thought, though they still offer financial advantages to employers.
What is vesting, and how does it work?
“Vesting” means ownership of retirement plan funds. Employee contributions are always 100% vested; however, employees earn the right to employer contributions over time, based on years of service or hours worked. If an employee leaves before fully vesting, the unvested portion goes into the plan’s forfeiture account. Vanguard reports that over half of the plans it administers include a vesting schedule for employer contributions.
Vesting schedules are defined in the plan document and may vary:
- Immediate Vesting: Full ownership from day one.
- Cliff Vesting: 0% vested until a set number of years, then 100%.
- Graded Vesting: Ownership increases gradually each year.
The table below shows the differences between a cliff vesting schedule and a graded vesting schedule. For cliff vesting, the account becomes 100% vested after a set number of years, whereas a graded vesting schedule has gradual increases over a set number of years. This example reflects a three-year cliff vesting schedule and a six-year graded vesting schedule.
| Years of Service | Cliff Vesting | Graded Vesting |
| 1 | 0% | 0% |
| 2 | 0% | 20% |
| 3 | 100% | 40% |
| 4 | 100% | 60% |
| 5 | 100% | 80% |
| 6 | 100% | 100% |
Why do employers use vesting schedules, and what did Vanguard’s research reveal?
Employers who use vesting schedules are generally motivated by two main goals: retaining employees by encouraging them to stay longer in order to earn full benefits and managing costs by recouping unvested contributions when employees leave the company.
Vesting schedules are a common strategy used by about two-thirds of employers to promote retention, but their effectiveness is often limited by a lack of employee understanding. Many workers are unclear on how vesting works, which diminishes its intended impact.
A research report by Vanguard further challenges the idea that vesting schedules significantly influence employee retention. When comparing plans with immediate and three-year cliff vesting, they found no major differences in turnover, and many participants weren’t even aware their plan included a vesting schedule, highlighting a communication gap.
Employers benefit financially by recouping an average of 2.5% of contributions through forfeitures. However, these savings often come at the expense of lower-income employees, whose final retirement balances may be reduced by about 40%. This underscores the need for plan sponsors to balance the cost-saving benefits of vesting schedules with their potential negative impact on lower-paid, high-turnover workers.
What should plan sponsors do?
1. Review Your Plan Documents
Confirm if your plan has a vesting schedule and how it works.
2. Know Who Manages Vesting
Vesting is typically tracked by the plan sponsor, recordkeeper, or third-party administrator (TPA).
3. Communicate Clearly
Help participants understand the vesting schedule because it could influence their decisions and boost retention.
4. Understand Forfeiture Rules
Know how forfeitures can be used (e.g., offsetting employer contributions or plan expenses) and ensure compliance with your plan document.
Want help understanding or reviewing your plan’s vesting structure? Reach out to your Shepherd Financial advisor today.
i Plan Sponsor Council of America, 67th Annual Survey of Profit-Sharing and 401(k) Plans.
ii Internal Revenue Service.
iii How America Saves 2024, Vanguard, available at: institutional.vanguard.com/insights-and-research/report/how-america-saves.html.
iv Plan Sponsor Council of America, 67th Annual Survey of Profit-Sharing and 401(k) Plans.
v Does 401(k) vesting help retain workers?, Vanguard, available at:
Understanding Forfeiture Accounts
People are generally most familiar with the plan’s investment options that are part of the plan’s core lineup. However, other plan assets for which plan sponsors have a fiduciary responsibility include the revenue credit account and forfeiture account. The names of these accounts may vary across different recordkeeping platforms.
Forfeiture Basics
Employee contributions are always 100% vested, meaning they belong to the employee when they leave. However, employer contributions may be subject to a specified vesting schedule, which determines when an employee gains ownership of any employer contributions. The forfeiture account is where these employer contributions are held when an employee leaves the company before becoming fully vested in those contributions.
Employers have the choice of how they want to use these funds. It is important to make sure the plan document, as well as any other plan documentation, specifies how the funds can be used. It is also critically important to ensure any plan documents align with what is actually happening. Common uses of the forfeiture funds include:
• Plan Expenses: Covering administrative costs associated with managing the plan.
• Employer Contributions: Reducing future employer contributions that the company needs to make to the plan.
• Reallocation to Participants: In some cases, the forfeited amounts can be reallocated among the remaining plan participants in a nondiscriminatory manner.
Proposed Regulation and Timing
As a practical matter, most plans try to spend the revenue credit account and forfeiture account within the plan year in which the funds were generated or, at the latest, by the end of the following plan year. This was formalized in 2023, when the Internal Revenue Service (IRS) proposed a regulation for defined contribution plans to require that forfeitures must be used no later than 12 months after the close of the plan year in which the forfeiture is incurred. While this remains a proposed rule, the timing guidelines should be followed.
Action Items for Plan Sponsors
• Understand where all the plan assets are even if those funds are not in the core investment lineup; this extends to holding accounts including the revenue credit account and forfeiture account.
• Determine how the forfeiture account can be spent as identified in the plan document or other governing documents and policies for the plan.
• Ensure the plan’s operation aligns with the plan documentation, including as it relates to how to spend forfeiture dollars.
• Determine a procedure to ensure forfeiture dollars are spent within the plan year in which the funds were generated or, at the latest, by the end of the following plan year.