Vanguard’s legal woes over the massive tax bills it handed unsuspecting customers are surfacing a sore point for some wealthy investors: Many firms don’t highlight the tax consequences of their investment funds.
Vanguard upset some retail investors earlier this year when it hit them with surprise tax bills stemming from moves by its corporate clients to sell their higher-cost target-date funds and shift into cheaper versions. The corporate clients are in tax-deferred 401(k) plans, which means they didn’t pass on immediate taxes to plan participants as part of the switch.
It was a different story for individual investors who hold the Vanguard funds in brokerage accounts. They got tax-whacked, some in the six figures or more. Target-date funds, which are typically mutual funds, consist of stocks and bonds whose mixes become more conservative over time as an investor ages.
The upset gained steam on March 14, when three retail customers sued Vanguard in a Philadelphia federal court, alleging that the switch caused the expensive funds to sell as much as 15% of their assets, in turn sending individual investors who own them shock tax bills.
The
The lawsuit, filed in U.S. District Court for the Eastern District of Pennsylvania, alleged that the giant investment firm, its top executives and trustees breached their fiduciary duty to put a client’s interest first and avoid conflicts of interest. It also asserted that Vanguard failed to adequately inform its retail customers of the tax consequences of the shift and to take steps to protect them.
Like regular mutual funds, target-date funds are best for investors in tax-deferred plans like a 401(k) or an individual retirement plan (IRA). Hold them in a taxable brokerage account, and you get hit with capital gains taxes whenever the fund sells assets. In the Vanguard case, most of the surprise taxes were for long-term gains on assets held for more than a year. Those are taxed at a top rate of 23.8%. But some were for short-term gains on assets held less than a year. Those are taxed at ordinary rates, now as high as 37% plus 3.8% for the Obamacare levy.
‘All this garbage’
Jonas Jacobson, a lawyer at Santa Monica, California-based Dovel & Luner who represents the plaintiffs, said that on the one hand, Vanguard’s fund prospectuses “recognize that taxable investors hold these funds and that these investors are vulnerable to capital gains taxes.” But he added that “while ordinary investors expected normal, small capital gains distributions, no investor expected that Vanguard itself would trigger an “elephant stampede” sell-off and massive distribution, solely to favor its larger retirement plans.” The elephant term was
“You get these giant prospectuses, all this garbage, that nobody reads,” said retirement expert Ed Slott, a certified public accountant in Rockville Centre, New York. “They’re so big, I used to use them as door stops.”
Emily Farrell, a Vanguard spokesperson, said that “we won’t be commenting” on the lawsuit.
Not alone
While Vanguard has grabbed the headlines, it’s not alone in slapping investors with outsize tax bills on target-date funds. Last year, Fidelity Freedom, T. Rowe Price Retirement and J.P. Morgan SmartRetirement all saw big net outflows that handed investors taxable distributions accounting for anywhere from 10.7% to nearly 14.4% of a fund’s assets,
U.S. target-date funds held around $1.8 trillion as of June 30, 2021,
The tax issue is intensifying as aging investors nearing retirement tap into their savings and investment firms compete ferociously for big institutional clients. In 2020, pandemic-spooked investors yanked a net $7.2 billion out of target-date funds, after sinking in nearly $60 billion in 2019 and more than $130 billion over the two prior years,
Things bounced back last year — but not for Vanguard. While the giant firm manages around $660 billion in the funds, it took in only $71 million in 2021, down from $2.7 billion in 2020, Morningstar
‘A straightforward approach’
Sometimes called “lifecycle” funds, target-date funds are marketed as a “set-it-and-forget-it” glide path to building a nest egg. So a fund with “2040” in its name is aimed at people who plan to retire that year. Robo investor
In a broad summary, Vanguard calls its Target Retirement funds “a straightforward approach to a sophisticated problem: how to invest successfully for retirement.” Nowhere does it mention in
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Some 99% of Vanguard’s target-date investors own their funds through tax-advantaged retirement plans,
“It’s mostly larger individual investors who need to beware [of] capital gains from target-date funds, not smaller investors,” Morningstar
‘Annoyed at myself’
One investor going by the name “lasater”
“I’m pretty annoyed at myself for not being more educated about how to select funds for taxable accounts (and/or choosing a wealth advisor who hopefully would have made smarter decisions), and at Vanguard (... who I think could have done a far better job of educating investors on this issue/risk),” "lasater" wrote.
The lawsuit concerns Vanguard’s handling of funds that come in two flavors, one for retail investors and small retirement plans with less than $100 million, and the other for bigger institutional plans. While the funds have the same strategy, managers and holdings, the ones for smaller investors cost more. In late 2020, Vanguard slashed the minimum investment for the lower-cost institutional funds to $5 million from $100 million. The change prompted a rush by institutional customers to switch over to the cheaper funds, in turn causing Vanguard’s Target Retirement 2035 and Target Retirement 2040 funds to sell nearly one-sixth of their assets to raise cash to redeem the higher-cost shares.
In a Dec. 2020
In a twist, Vanguard
But the harm has already been done, the complaint said: “While this didn’t hurt retirement plans, it left taxable investors holding the tax bag.”
