Vesting: What is it and how it works

Vesting is a legal term that refers to a point after a specific time period, known as a vesting period, at which a person acquires legal ownership of some kind of property. The person then has a "vested right" to that asset. Nobody can take it away from them, even if they don't yet have the asset in their tangible possession. This article explores the different types of vesting, how they work in practice, and why companies use vesting as a strategic tool for both employee retirement plans and equity compensation, which is especially important when research shows only 21% of employees worldwide are engaged in their work.

What is vesting?

Vesting gives employees legal ownership of workplace benefits over time. Whether it's stock options or retirement plan contributions, vesting ensures you earn these valuable assets by staying with your employer for a specified period.

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How does vesting work?

A vesting schedule sets the timeline for when you gain ownership of these benefits. For retirement plans, you'll need to work a certain number of years before employer contributions become yours to keep.

The specifics vary by benefit type. Government regulations limit how long retirement vesting can take, while equity vesting terms are typically negotiated during your hiring process.

Types of vesting

Vesting isn't a one-size-fits-all approach. Companies typically choose from a few common structures depending on their goals. Understanding these types can help you see how your benefits will accumulate over time.

• Time-based vesting: This is the most common type. You earn ownership of your assets gradually over a set period of employment. For example, you might earn 25% of your stock options for each year you work at the company.

• Milestone-based vesting: With this approach, you earn ownership when specific, predetermined goals are met. These milestones could be tied to individual performance, a team project's completion, or a major company event like an initial public offering (IPO).

• Hybrid vesting: Some plans combine both time- and milestone-based approaches. For instance, you might need to be employed for at least one year and have your team achieve a certain target before your first set of shares vests.

Vesting schedules and periods

A vesting schedule is the timeline that dictates when you gain full ownership of an asset. Most schedules include two key components:

• Vesting cliff: An initial period (often one year) where nothing vests. Leave before this point, and you get nothing.

• Graded schedule: After the cliff, you earn ownership in smaller increments over time. For example, the IRS provides a sample 6-year graded vesting schedule where an employee is 20% vested after two years and gains another 20% each year until becoming fully vested after six years.

Here's a common example: 25% of your shares vest after one year, then the remaining 75% vests monthly over the next three years.

Why do companies use vesting?

Companies tend to introduce vesting periods to improve retention and reduce turnover, which helps employers save on recruitment and training costs; according to Gallup, highly engaged teams can experience 51% less turnover than their less-engaged counterparts. With vesting schedules, companies can confidently offer their employees perks like retirement matching and equity without worrying about losing money on an employee who doesn't stick around.

What is stock vesting?

Vesting schedules can also be applied to employee stock options or company shares. Employees who get non-qualified or incentive stock options on a vesting schedule don't get those assets immediately. Instead, they're given the right to exercise stock options. In other words, they can buy a certain number of shares at a fixed price in the future.

There is also the option of giving employees restricted stock units. In this case, they get actual shares of stock, which they're permitted to sell later. A vesting schedule applies, so employees must stay at the company for a certain period.

Most equity follows time-based vesting—you earn shares by staying employed for a certain period. Some companies use milestone-based vesting instead, where you earn equity by hitting specific goals like completing projects or reaching an IPO.

Time-based vesting is far more common since it's simpler to manage and provides predictable retention incentives, with the U.S. Bureau of Labor Statistics noting the typical vesting requirement is five years of service.

What is 401(k) vesting?

A 401(k) is a type of tax-advantaged retirement plan that's company sponsored. U.S. employers may offer their employees this plan. Employees who opt to sign up for a 401(k) agree to have a portion of every paycheck they receive deposited into an investment account. Depending on the terms, the employer may match part or all of the employee's contribution.

When discussing retirement plan benefits, the vesting schedule determines when the employee fully owns the retirement assets, giving them nonforfeitable rights. The balance generally depends on time. While the amount deducted from the employee's paycheck is theirs no matter what—they retain the rights to that money—they don't get immediate rights to the employer-matched amount.

The money from the employer must vest before it becomes the employee's. Once the vesting period concludes, the employee is what's known as "fully vested." According to the IRS, 401(k) plans can offer a variety of different vesting schedules, ranging from immediate vesting to cliff vesting after three years or a graded schedule. They then have full rights to their contributions and the employer's contributions.

What happens to unvested 401(k) contributions? Here's the bottom line:

• You lose it: Any unvested employer contributions stay with the company when you leave, as IRS rules state these amounts are forfeited by employees upon termination.

• Your contributions stay yours: Money you contributed from your paycheck always belongs to you

Walking away from unvested benefits is essentially leaving free money on the table.

Building competitive compensation packages globally

Understanding vesting is key for both employees and employers. For companies, it's a powerful tool for retaining top talent and aligning everyone toward long-term goals. For employees, it's a critical component of a competitive compensation package that builds personal wealth.

As companies build distributed teams, navigating equity and benefits across different countries adds another layer of complexity. Creating a fair and compliant total rewards strategy is essential for attracting the best talent, no matter where they live. If you're ready to build a global team with competitive and compliant benefits, you can start hiring globally with a platform that simplifies the entire process.

FAQs

What does it mean to be 80% vested?

Being 80% vested means you own 80% of your benefits and can take that portion with you if you leave. The remaining 20% stays with the company.

What does it mean to be vested after 5 years?

This means you become 100% vested after five years of service. You'll own all employer contributions and can take everything with you if you leave.

What does 3 year vesting mean?

You'll become fully vested after three years of service. This could happen all at once (cliff vesting) or gradually over time (graded vesting).