Viewpoint: Are 401(k) Vesting Schedules in Need of an Update?

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Businesses today must be nimble to successfully compete for talent. The influx of Millennials into the workforce has required employers to revamp the types of benefits they offer, how they are communicated and how they are structured.

Employees are now often auto-enrolled in a 401(k) plan, have the option to make post-tax Roth contributions, have target-date funds available to assist with investing, and have resources that are available and communicated in mobile-friendly formats. However, one facet of the 401(k) that is due for an update is the vesting of employer match contributions.

Two components are at play when evaluating a 401(k) plan's employer match:

• The match amount is the attraction tool which, if above what an employer's competitors are offering, is touted by talent recruiters and hiring managers when presenting the overall benefits package to prospective employees.
  
  
• The vesting schedule, commonly six years, is the retention tool by which employers reward and encourage loyalty and longevity within an organization.
  

Workers' average tenure with an employer has plummeted over recent decades and now stands at 4.2 years, according to the Bureau of Labor Statistics. Yet 401(k) vesting schedules have remained nearly unchanged.

Millennials and other workers starting their first full-time job—or at least their first job that offers a 401(k)—may not be aware of a company match, much less ask about its vesting schedule. If this plan feature is not fully explained during onboarding, they may be disappointed when they leave the company and realize that the account balance they can take with them is not as large as they thought. Moreover, as commendable as it is when younger workers commit to contributing up to the matching percentage or beyond, there is a risk of disenchantment that may dampen their future 401(k) savings habits when they are, say, a mere 20 percent vested in their matching funds upon departure.

How might matching and vesting be revamped? Employers that use the popular six-year graded (or graduated) vesting method, which increases the employee's vested percentage for each year of service with the employer, could move to a three-year cliff vesting approach, where participants are 0 percent vested until completing three years of service, at which time they become 100 percent vested. 

Adjusting the Formula

Companies would need to examine their turnover rate to see if this option makes sense. If turnover is high in the first two years of employment, for example, and then levels off, there would be no additional cost to the company for those who leave during this time frame. In addition, three-year vesting may entice those who are contemplating leaving to stay and contribute to the organization at least another year.

Another option is to take advantage of a safe harbor plan design, which eliminates the requirement for annual nondiscrimination testing.

Compliance testing must be performed annually to ensure that a plan does not benefit highly compensated employees (HCEs) more than non-highly compensated employees. According to the IRS, an HCE is someone who is a 5 percent owner in the current or preceding year or who had compensation exceeding $120,000 (for 2016) in the preceding year. In short, if the plan fails the testing, then a portion of HCEs' contributions must be returned to them by March 15 or a contribution must be made to the accounts of non-HCEs, sufficient to bring the plan into compliance.

Returning a portion of HCEs' contributions does not tend to be a popular option among that group. Employers can eliminate the need for annual testing and its risk of failure by adopting a safe harbor plan design, under which the automatic contribution level (amount deferred from employees' salaries) and employer contribution levels must both meet certain base lines.

Removing the burden of annual compliance testing is in and of itself a benefit to the organization, as well as to the HCEs who would have a portion of their matching dollars returned to them in the case of testing failure. However, along with the safe harbor comes the requirement that the company contribute a minimum amount to participants' accounts, in which they are immediately 100 percent vested. This could be a selling feature that would stand out when recruiters market open positions to anyone, not just younger workers.

It's unimaginable to think that we will ever again return to an era when employees expect to spend a decade or more at one organization. It's time for employers to face this reality and adjust their matching and vesting philosophy so that it continues to play an important role in their total rewards strategy.

Joseph B. "Jay" McGhee, SHRM-CP, is an HR and employee benefits professional in Richmond, Va.