Vesting - Explained
What is Vesting of Rights and Ownership?
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Table of ContentsWhat is Vesting?How is Vesting Used? Vesting in Employee BenefitsVesting in Qualified retirement plans Vesting SchedulesStock incentive Vesting Benefit of Stock VestingDrawbacks of Stock VestingVesting in InheritanceAcademic Research on Vesting
What is Vesting?
Vesting in law is a term that means to confer or bestow upon a person or entity a secured right to an asset or benefit whether in the present or to be received in future. A vested right to a present or future possession is secured and it cannot be taken away by a third party. Generally, the term is synonymous with employee benefits such as retirement plans and stock bonuses. The term is also common in real estate as well as in inheritance law.
How is Vesting Used?
With respect to companies, the reason why vesting policies exist is to encourage employee retention. This is because when a company vests certain right to an employee for possession of a future asset, usually the employees has to stay in the company for a certain number of specified years in order to enjoy the vested interest. If the employee leaves, the right to certain assets or payments will be forfeited. For instance an employee will contribute to an employee retirement plan or allocates restricted shares to the same employee to encourage longevity within the organization. This is mostly because the company feels the employee skill set bring more value to the organization and they dont want to lose the employee. Therefore, the employee will have to stay longer with the company in order to fully earn the rights to the employer incentive.
Vesting in Employee Benefits
Vesting for employees may take two forms; employer-provided stock incentives or contribution made towards a qualified retirement plan for the employee.
Vesting in Qualified retirement plans
Qualified retirement plans come in either two types; a defined benefit plan or a defined contribution plan, though there is also a hybrid of both called a cash balance plan. An annuity pension plan is an example of a defined benefit plan. Defined contribution plan, on the other hand, are several including a 401(k) plan, 403(b) plan, a 457(b) plan, Simplified Employee Pension (SEP) and Savings Incentive Match Plan for Employees (SIMPLE) among others. An employee contribution directly to a defined contribution plan such as a 401(k) plan vest immediately and the employee is not at risk of forfeiting their contribution in case of termination of employment either voluntarily or involuntarily. Employees can rollover one hundred percent of their 401(k) contributions into another employer's plan. This means the portion contributed belongs to the employee fully irrespective of how long one works with a particular company. However, contributions made by the employer may not vest immediately but may be subject to a vesting schedule provided by the employer. This is especially true where the employer part of employee benefit package involves contributing a match to what the employee contributes to the retirement plan. Generally, most companies contribute fifty percent or less of what the employee contributes and few are generous to offer a matching contribution.
There are generally three basic types of vesting schedules for retirement accounts: immediate vesting, cliff vesting, and graduated or graded vesting.
- a) Immediate vesting:
Employees who are immediately vested gain 100% ownership of their employer's matching contribution in their account balance from the time employer contributions are made. Approximately half of all companies offer immediate vesting for matching contributions. In case of employment termination, the employee does not forfeit any portion of the employer contribution and take home full ownership of their employer's matching contribution. Safe Harbor 401(k) plans are a good example of an immediate vesting schedule. Generally, there are certain circumstances that demand some employee to be immediately vested for their employer contribution.
- b) Cliff vesting:
This vesting schedule provides or transfers 100% ownership right of an employers contribution to an employees retirement plan at a specific date in future in one big chunk as opposed to gradual vesting over a specific period of time. This schedule is widely used by startup companies to keep employees long enough as well as to evaluate them before committing to them their full range benefits. The U.S The Pension Protection Act of 2006 stipulates that cliff vesting schedules should not exceed a three year period in defined contribution plans such as a 401(k). If an employee leaves an organization before the expiry of the stipulated period, they forfeit all their employer matching contribution to the plan.
- c) Graded or Graduated Vesting:
This schedule gives employees a gradual increase in the ownership of matching contribution by employer to a qualified retirement plan over a defined period of time. For example, a five-year graded vesting may include, Year one: 0% vested, Year two: 25% vested, Year three: 50% vested, Year four: 75% vested, and finally Year five: 100% vested. If the employee leaves before five years are up, lets say year three, the employers will claim on only fifty percent of the employers matching plus his / her own contribution and forfeit the other half the employers matching contribution to the retirement plan. Federal law sets a six-year maximum on graded or graduated vesting schedules for retirement plans.
Stock incentive Vesting
Some employers will offer their most valuable staff stock bonuses as part of the employee benefit package or compensation. This is primarily to entice employees and ensure they stay long enough to assist in achieving the company vision. The company might issue lets say one thousand shares but with a five-year gradual vesting schedule of probably twenty five percent. The stocks issued are usually restricted stock units. A restricted stock unit means that the employee does not own the shares yet which are subject to the employee achieving set milestone. Mostly, it is upon the employee remaining with the issuing company for a determined period of time that the shares are made available. Until the actual shares are allocated, the grant holder has no voting right and neither do they receive dividend. The restricted stock unit can be issued with either a cliff or graded vesting schedule. A good example is Facebook, when the company started it had not optimized on advertisement to generate revenue. An artist who worked for Facebook dealing with the office plan accepted stock compensation instead of cash. When the company went public in 2012, the artist became an instant multimillionaire since his shares are said to be valued at two hundred million dollars. Also, an employee may be given a stock option at a certain strike price. Stock options are exercisable at a future date and this presents an opportunity for an employee to profit from the stock option if the price of the stock will have appreciated above the strike price.
Benefit of Stock Vesting
Stock vesting has several benefits to both the employee and the employer including:
- The company does not incur cash payout or expenses since there is no outflow of cash to compensate an employee but rather stock ownership.
- The employee benefits by putting them in a position of owning a companys asset with probability of higher value return at maturity.
- The employee has an inherent obligation to perform well and achieve set milestones since the performance is tied to vested stock offered as part of the employment contract.
- Employees are enticed to stay in hope that they too may be prospect to offers or rewards in form of vested shares.
- Startups are able to retain talent at a low salary but with an additional vested stock to cover for the lower pay to qualified employees.
Drawbacks of Stock Vesting
- The down side to vested shares is that they have a complicated tax system that depend on when one chooses to buy or sell, the types of vesting schedule. Restricted share units taxation is governed by Section 1244 of the U.S Internal Revenue Code (IRC)
- The vesting is done on a long term basis and the employee risks losing the vested shares if he or she doesnt remain with the company during the entire vesting period.
- New employed persons may not receive benefits in the first year whether it is a gradual or cliff vested share.
- The employee with vested share interest does not receive dividends or either vote in the annual general meeting since no shares have been actually issued until the vested period lapses.
Vesting in Inheritance
In probate and administration vesting is used to avoid dispute as to the time of death and also to avoid possible double taxation due to subsequent succession in case of death of several heirs due to a natural calamity or disaster. A testator may include in his or her will a vesting period in case of death of one or several chosen heirs and conditions on how to distribute the estate bequeathed to the deceased heirs after the lapse of the vesting period.
Academic Research on Vesting
- Stock and option grants with performance-based vesting provisions, Bettis, C., Bizjak, J., Coles, J., & Kalpathy, S. (2010). The Review of Financial Studies, 23(10), 3849-3888.
- Accelerated vesting of employee stock options in anticipation of FAS 123R, Choudhary, P., Rajgopal, S., & Venkatachalam, M. (2009). Journal of Accounting Research, 47(1), 105-146.
- Performance-vesting provisions in executive compensation, Bettis, J. C., Bizjak, J., Coles, J., & Kalpathy, S. (2018). Journal of Accounting and Economics.
- Equity vesting and managerial myopia, Edmans, A., Fang, V. W., & Lewellen, K. A. (2013). National Bureau of Economic Research.
- Stock option vesting conditions, CEO turnover, and myopic investment, Laux, V. (2012). Journal of Financial Economics, 106(3), 513-526.
- Stock option grant vesting terms: Economic and financial reporting determinants, Cadman, B. D., Rusticus, T. O., & Sunder, J. (2013). Review of Accounting Studies, 18(4), 1159-1190.
- Equity vesting and investment, Edmans, A., Fang, V. W., & Lewellen, K. A. (2017). The Review of Financial Studies, 30(7), 2229-2271.
- Accounting for risk aversion, vesting, job termination risk and multiple exercises in valuation of employee stock options, Leung, T., & Sircar, R. (2009). Mathematical Finance: An International Journal of Mathematics, Statistics and Financial Economics, 19(1), 99-128.
- Strategic news releases in equity vesting months, Edmans, A., Goncalves-Pinto, L., Wang, Y., & Xu, M. (2014). National Bureau of Economic Research.
- Equity vesting and managerial myopia, Edmans, A., Fang, V., & Lewellen, K. (2014).
- Qualified Pension and Profit-Sharing Plan Vesting: Revolution Not Reform, Osgood, R. K. (1979). BUL Rev., 59, 452.