Cliff vesting is one type of vesting schedule that is used with many types of retirement plans. Vesting defines the percentage of the account balance that the participant is entitled to when speaking of a retirement plan.
It is common for employers to set a schedule which assigns a particular percentage of vesting based upon how long the employee remains with the company. A common arrangement vests 20% per year so that an employee who remains in service for five years would be fully vested.
Cliff vesting is different. Unlike plans which give the employee ownership of a percentage of their retirement fund on a schedule, this type of vesting requires the employee to complete a number of years before the whole account becomes vested. This period can be no longer than five years.
For the employer, cliff vesting encourages employees to remain at the firm for a minimum number of years to ensure that their retirement account is vested. If they leave before the term is up they lose all the non-vested funds that have been placed into the account through matching. Furthermore, if they change jobs they may have to start again at the beginning of a vesting period at another company.
There are some stipulations that the employer must adhere to. For example, in the case of a 401(k) it can take no more than three years for a plan to be fully vested under a cliff vesting agreement. If the employee reaches retirement age before the term is complete, they are automatically fully vested, as long as they are still employed on that date. Finally, no vesting requirement can be connected to employee contributions.