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Vesting Alternatives

Overview

Vesting requirements are often imposed on employer contributions and associated account balances in a Nonqualified Deferral Plan (NQDP). Vesting requirements are a commonly-used strategy to retain key employees. Vesting gives the participant a non-forfeitable right to his account balances derived from employer contributions over a certain period of time. The period of time for full vesting (i.e., the time at which a participant may leave the employ of the company with the right to 100% of his account balances) may vary from 100% vesting immediately, to a percentage of the account balance vesting each year. Years, for vesting purposes, are usually measured in one of two ways:

  • Years of Service
  • Years of Plan Participation

Years may be based on completed years or nearest years. Participants in a plan that bases its vesting schedule on completed years must remain with the company through the anniversary date of their date of hire or their date of participation in order to be fully vested for that year.

Completed Years Vesting Example:
Mr. Jones is a participant in a NQDP which measures its vesting years by years of service. Mr. Jones was hired by the company on June 6, 1990, and decides to leave the company 5 years later on May 12, 1995. Because Mr. Jones left before his years of service anniversary date, he will only be credited with 4 years of vesting.

Participants in a plan that uses a nearest years vesting schedule would be credited with the current year's worth of vesting once they complete more than 50% of that vesting year.

Nearest Years Vesting Example:
Ms. Smith is an executive in a NQDP using a years of plan participation vesting schedule. Ms. Smith joined the plan on June 6, 1990, then leaves the company 5 years later on April 3, 1995. She would be credited with a full five years of vesting since she remained in the plan for more than 50% of that vesting year.

Participants are always 100% vested on account balances associated with their own deferrals.

Vesting Schedules
Common patterns (schedules) of vesting include:

  • Full and Immediate Vesting - All account balances vest immediately.
  • Graded Vesting - A percentage of the account balance vests each year. An example of a graded vesting schedule would be 20% per year for 5 years.
  • Cliff Vesting - Full vesting occurs after a specified number of years, with no partial vesting at all

Class Year Vesting
Class Year Vesting , in essence, treats each calendar year of deferral as a separate entity.

Class year vesting results in each calendar year's deferrals vesting separately, according to the vesting schedule selected. For example, assume that a graded vesting schedule of 20% per year was applied on a class year basis. Then the following would occur:

  • Year 2000 deferral account balances would be 20% vested in year 2000, 40% vested in year 2001, 60% in year 2002, etc.
  • Year 2001deferral account balances would be 20% vested in year 2001, 40% vested in year 2002, etc.

Choosing an Appropriate Vesting Schedule
A sponsor may choose any vesting schedule. There are no statutory requirements for a NQDP.

Here are some practical considerations:

  • Full and immediate vesting is obviously the choice that will achieve the most satisfaction with plan participants. However, it will also accelerate the corporate liability growth. It is also the simplest form of vesting to use when considering the new FICA and FUTA withholding rules. The new rules require FICA withholding on the portion of the employer account balance that vests each year. Once taxed for FICA purposes, any future growth on that portion of the balance escapes future FICA tax. Any graded vesting schedule will require a complex record keeping system to keep track of what portions have already been taxed. 

  • Cliff vesting provides the slowest growth rate of corporate liability, but results in a spike at the end of the cliff period. It also simplifies the calculation of FICA/FUTA taxes as stated above.
  • The major benefit of class year vesting is the minimization of the rate of corporate liability growth. For any given schedule other than full and immediate vesting, class year vesting will increase liabilities at a slower rate than the same schedule utilized without the class year option.

 

 

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