VESTING | Plan Qualification Requirements

A qualified plan must provide a minimum nonforfeitable, or vested, benefit for participants who attain certain service requirements. Once vested, the participant cannot forfeit this minimum vested benefit. For example, the plan cannot require that an employee forfeit part or all of the vested benefit required by the Code even if the employee commits an act of misconduct, such as embezzlement or going to work for a competitor. The strictness of the vesting rules was designed to provide additional benefit security and to protect employees against arbitrary acts of the employer.

Vesting at Normal Retirement Age and Termination of Employment
The plan must provide a fully vested benefit at the normal retirement age. The plan must also provide that benefits are vested under a specified "vesting schedule" during the participant's employment, so that if the participant terminates employment prior to retirement age, he or she is entitled to a vested benefit with some stated minimum amount of service. The vested benefit can be payable immediately on termination or deferred to the plan's normal retirement age.

If the plan provides for employee contributions, the participant's accrued benefit is divided between the part attributable to employee contributions and the part attributable to employer contributions. The part attributable to employee contributions must at all times be 100 percent vested. The part attributable to employer contributions must be vested in accordance with a vesting schedule set out in the plan.

There is some flexibility in designing a vesting schedule in order to meet various employer objectives. However, the vesting schedule must be at least as favorable as one of two alternative minimum standards, five-year vesting or three-to seven-year vesting.

Five-Year Vesting
The vesting schedule satisfies this minimum requirement if an employee with at least five years of service is 100 percent vested in the employer-provided portion of the accrued benefit. This rule is satisfied even if there is no vesting at all before five years of service. This rule is sometimes referred to as cliff vesting.

Years of Service - Vested Percentage

3 - 20

4 - 40

5 - 60

6 - 80

7 or more - 100

Three-to Seven-Year Vesting
A vesting schedule satisfies this minimum standard if the vesting is at least as fast as in the following table on the right:

In applying the vesting rules, all of a participant's years of service for the employer must be taken into account, even years prior to plan participation, except that years of service prior to age 18 may be excluded. The plan's vesting schedule may also ignore service prior to a break in continuous service with the employer; however, there are elaborate restrictions on how this may be done [Code Section 411(a)(6)].

Probably the most common vesting provision in defined-benefit plans is the five-year provision, because of its simplicity and because it is generally the most favorable to the employee. Defined-contribution plans are often designed with a more generous (to the employee) vesting schedule using the three- to seven-year schedule or one that is even faster.

Top-Heavy Vesting
To complete this discussion, it should be mentioned that plans that are top-heavy, as defined in the Code, are required to provide faster vesting than under most of the schedules previously mentioned. The top-heavy minimum vesting schedule is shown in the table at the left:

Years of Service - Vested Percentage

2 - 20

3 - 40

4 - 60

5 - 80

6 or more - 100

A 100 percent vesting provision with two years' eligibility also meets the top-heavy minimum vesting requirement. As discussed below, the top-heavy requirements have a significant impact in designing a vesting schedule for plans of smaller employers.

Choosing a Vesting Schedule
Choosing an appropriate vesting schedule is an important plan design decision. When a pension plan participant terminates employment, invested funds contributed to the plan for that participant in excess of any benefits paid to the participant on termination (forfeitures) are generally used to reduce future employer costs for the pension plan. Strict vesting, therefore, can reduce a pension plan's cost to the employer. In a defined-contribution plan, forfeitures also can be reallocated to remaining participants' accounts. Thus, there should be a reason for adopting more than a strict minimum vesting schedule. Some reasons for using liberal vesting include the need to provide employee incentive and involvement in situations where a five-year vesting schedule might appear too remote and therefore of no value to employees. Also, a simplified liberal vesting schedule may reduce administrative costs.

Vesting on Plan Termination
The final vesting rule relates to a plan that has terminated. The IRS will regard a plan as having terminated either if it is formally terminated or if the employer permanently ceases to make contributions to the plan. When a plan is terminated, all benefits must be fully vested to the extent funded. Therefore, when a defined-contribution plan terminates, all participants are immediately 100 percent vested in their account balances. When a defined-benefit plan terminates, participants are 100 percent vested in their accrued benefits; however, if the plan funds are insufficient, they are vested only to the extent that the plan is funded. Many terminated qualified defined-benefit plans are insured by the Pension Benefit Guaranty Corporation (PBGC).