Thinking Through the New Vesting Rules

The recently passed pension reform bill accelerates vesting requirements for all defined contribution plans. Account balances now must vest not later than after three years of eligible service for cliff vesting and six years for graded vesting, starting at no less than 20% per year after two years of service. Existing ESOPs that are repaying a loan in place as September 26, 2005, however, would not be subject to these rules for shares acquired by the loan for any plan year beginning before the earlier of the date the loan is fully repaid or the date on which the loan was scheduled to be repaid as of September 26, 2005. The new rule takes effect for contributions made after December 31, 2006.

Plan documents will need to be changed to reflect this, and employees will need to be notified. Before doing this, however, companies need to think through what they want to do. While it may be tempting to use the maximum vesting schedules allowed, it may also not be worth the bother. For cliff vesting, the new rules essentially only mean employees who would leave in the fourth of fifth years of service will now be vested; for graded vesting, only those in the seventh year, and then only for an additional 20% of their account balances. In many companies, turnover data will show very little turnover during these years, meaning using the slower vesting schedules for existing contributions (or shares purchased with qualifying loans) will have no appreciable impact on repurchase obligation. Communicating two different sets of vesting rules will cause confusion and maybe even cynicism, so making the new rules only prospectively applicable may not be worthwhile. For other companies, however, there could be enough of a cash flow issue, or there may be loan covenants in place, that make the change impractical.

So before making a decision, companies should conduct a careful review of their demographics and repurchase obligations, as well as any binding commitments with lenders. Whatever decision is made needs to be clearly explained, not just communicated, to employees. Rationales for the change should be included.