Explaining Cliff Vesting: How it Works and Examples

Key Takeaways

• Cliff vesting is the process in which an employee becomes wholly vested on a certain date instead of in progressive totals over a lengthy period. 

• Cliffs typically last between one and four years, depending on the company, and culminate with full employer vesting.

• Vesting schedules can be based on time, milestones, or a combination of milestone and time based.

If retirement is on the horizon, and one’s employer offers retirement benefits, it is essential for planning purposes to understand cliff vesting. After all, the process means full benefits as opposed to a portion of benefits over time. Here is cliff vesting, how it works, and how to maximize funding for one’s Golden Years.

What is Cliff Vesting?

Cliff vesting is the process in which an employee becomes wholly vested on a certain date instead of in progressive totals over a lengthy period. 

Once they are eligible to receive benefits from their employer’s retirement or stock option plan, the employee is deemed “vested.”

Another way to explain cliff vesting is that, when companies offer equity to employees in their pay package, such employees must wait a period before they own it. Employees who leave their employer before becoming fully vested are ineligible for retirement benefits.

What are the Types of Cliff Vesting?

Vesting schedules can be based on time, milestones, or a combination of the two.

With time-based vesting schedules, employees are permitted to earn equity over a period. Note that, to exercise any options, most employees must remain at their employer for a year minimum.

Milestone investing is based on completion of a specific effort. Here, employees earn shares or options once a project is finished or the company meets a business goal, such as an IPO. 

Then there is mixed or hybrid investing, which is a combination of milestone and time-based investing. Before they can receive shares or options, the employee must remain with their employer for a certain period.

What are the Pros of Cliff Vesting?

Companies as well as employees benefit from employment longevity. In particular, the prospective employee may be lured by a short vesting cliff period. Otherwise, they may have to wait longer for full vestment in their company’s benefit plan.

Further, employees can generally be encouraged by cliff vesting to remain with the company and perform well. Companies are able to maintain a good working relationship with their employees while rewarding loyalty. 

What are the Cons of Cliff Vesting?

To some employees, cliff vesting can seem risky.  Many people have heard about a company terminating a contract right before completion of the initial vesting cliff qualifying period. The business could be taken over, for example, or there may be a buyout. Circumstances could also involve a new company failing prior to the vesting date. Also, the employee could leave before the date or even get fired.

Cliff investing can also possibly disincentivize long-term employees who may feel as though they should already be entitled to their entire share of their employer’s stock. Instead, they must wait longer. This could result in negative feelings among these employees.

How Do Vesting Schedules Work?

Companies have vesting schedules to prevent employees who do not remain with them from taking with them their employer retirement contributions. Another way to say it is, they offer vesting to incentivize people to stick with them.

Various plans have varying vesting schedules. A vesting schedule specifies when an employee finally owns there employer-sponsored stock options or retirement account contributions. 

Typical plans are for four years with a one-year “cliff.” Cliffs typically last between one and four years, depending on the company, and culminate with full vesting. Here, if stock options are in play, the employee would have 25 percent of their shares vested after a year.  For each subsequent month they remain with their employer, they get 1/48 of their shares invested. They are fully invested after four years.  

With a one-year cliff, once the employee reaches their one-year work anniversary, they will be completely vested in all employer contributions and any future contributions. The scenario is the same for two-, three-, or four-year cliff vesting plans.   

How Does Cliff Vesting Differ from Graded Vesting?

The difference between cliff and graded vesting is that the former occurs all at once on a certain date, such as after four years of employment. By contrast, graded vesting happens over time in increments. If it’s a 10-year vesting period, for example, the employee after two years is 20 percent vested, 30 percent after three years, and 100 percent following 10 years.

Why is Cliff Vesting Volatile?

Generally, cliff vesting can help shield investors against market volatility. However, employees may miss out on prospective gains if their employer’s stock price falls markedly during the vesting period. Why? Because their shares cannot be sold until the vesting period ends, even if the stock prices keep dropping.

What Happens When You Become Fully Vested?

After an employee is vested, their employer may place the funds in a retirement plan that is either a defined benefit plan or a defined contributions plan.

• Defined benefit plan. This is where the company provides all the plan funds. A pension is an example.  Each year, the employee gets a certain amount of benefit.  How much the employee gets depends on how much they were making in their final year and how long they were with the company. There may be other factors involved and which must be delineated in the original pact.
• Defined contributions plan. With such a plan, the contributes an established amount of their salary to it during their service. Oftentimes, the employer will match those funds. A 401(k) is a plan example. How much the employee gets will vary depending upon the investments chosen, usually through at least one mutual fund.

How to Maximize Your Retirement?

There are ways to get the most out of one’s retirement outside of through employer plans. One can begin a rollover individual retirement account, for example. Adding alternatives – assets other than stocks and bonds – to one’s retirement portfolio has historically been a complicated process with high fees involved.

That is no longer necessarily true, at least not if one goes through Yieldstreet. As one of the leading alternative investment platforms, Yieldstreet permits investors to seamlessly diversify their positions with private-market alternatives such as art and real estate. Yieldstreet’s IRA traverses such asset classes and more and offers a retirement calculator to help with planning. 

The primary aim is to create retirement portfolios that are less reliant upon a constantly fluctuating stock market. With the addition of private-market investments to their tax-favored account, once can potentially maximize returns.  

Diversification, which does not end with taxable accounts, is a major benefit of private-market investments. In fact, building a portfolio of varying asset classes and anticipated performances can help mitigate risk as well as guard against inflation and potentially improve returns.

Alternative Investments and Portfolio Diversification

Alternative investments can be a good way to help accomplish this. Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings. 

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk. 

In some cases, this risk can be greater than that of traditional investments.

This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million.  These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform.

However, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other alternative investments. 

Moreover, investors can get started with a relatively small amount of capital. Yieldstreet has opportunities across a broad range of asset classes, offering a variety of yields and durations, with minimum investments as low as $10,000.

Learn more about the ways Yieldstreet can help diversify and grow portfolios.

Summary

Understanding the vesting process, as it applies to both retirement and pension plans, is key to retirement planning. After all, there are pros and cons for participation, with timing playing a crucial role. Before signing on, employees should ensure they are comfortable with their vesting schedule terms.

Remember, too, that beyond employer plans, there are other ways to maximize retirement that can also diversify one’s investment portfolio.