As a plan sponsor, you may be using vesting schedules to encourage employee retention, but new research from Vanguard reveals that this strategy may not be as effective as you think. In reality, vesting schedules do little to keep employees from leaving – and they might actually be creating unnecessary administrative costs for your company.

What is a vesting schedule? While the funds that an employee contributes to the plan as an employee deferral are always fully vested, you are permitted to establish length-of-service requirements that employees must meet to be fully vested in the employer contribution portion of their account balance. The schedule may be a cliff schedule, such as 100% vested after 3 years, or a graded schedule, such as 20% per year until fully vested after 5 years. If a participant terminates employment before reaching normal retirement age and takes a distribution prior to becoming fully vested, the non-vested portion remains in the plan as a forfeiture. Provisions in the plan document define how forfeitures can be used, with options including using the funds towards certain plan expenses, reducing employer contributions, or adding to employer contributions.

Vanguard’s analysis of 4.7 million job separations from 2010-2022 found that vesting schedules do not significantly impact employee retention. In fact:

• 30% of job separations involved forfeited, unvested contributions.
• Employees who hit a key vesting milestone were no less likely to leave than those who hadn’t yet reached a milestone.
• Only 33% of participants know whether their plan has a vesting schedule, making it unlikely to influence their decisions.

While forfeitures from unvested contributions can reduce costs, the financial gain is modest, recouping roughly 2.5% of employer contributions. If vesting schedules do not significantly boost retention or cut costs, why keep them?

Switching to immediate vesting could offer stronger benefits for both your employees and your organization.

• For participants: Immediate vesting strengthens retirement security by allowing employees to keep the full value of their employer contributions, which is often a substantial portion of their savings. This can improve financial well-being and promote greater engagement with the plan.
• For plan sponsors: Immediate vesting simplifies plan administration and reduces compliance risks presented by possible distribution overpayments. It could also help you qualify for safe harbor status, potentially exempting your plan from annual nondiscrimination testing if you opt for a fully vested contribution.

Data from a 2023 Vanguard study indicates that 1 in 4 participants were deferring less than 4%. This not only affects their employee contribution balance but also limits the amount of employer matching contribution they are eligible to receive. For participants with low deferral rates, a discussion with them may help determine the reason behind the election. Maybe the plan has a matching contribution but they forgot or maybe they have questions about how the vesting schedule works for the account balances. Understanding the participants’ perceptions of the plan is helpful in knowing where changes would be beneficial.

Vesting schedules are not without merit, but may not be the retention tool they were once thought to be and might come with additional downsides. Immediate vesting, on the other hand, could provide a win-win scenario for both plan sponsors and plan participants. We are always happy to discuss the impact that each can have on your plan.

Vanguard studies:

https://corporate.vanguard.com/content/dam/corp/research/pdf/does_401k_vesting_help_retain_workers.pdf

https://institutional.vanguard.com/content/dam/inst/iig-transformation/insights/pdf/2023/how-americans-can-save-more-for-retirement.pdf