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Regulation and Compliance > Litigation

Vanguard Hit With Class-Action Suit Over Target Date Fund Tax Bills

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What You Need to Know

  • Vanguard opened its Institutional Funds to all retirement plans with at least $5M, causing a wave of redemptions that forced the Retail Funds to sell assets.
  • Those asset sales left retail investors with huge realized capital gains, according to the suit.
  • The suit alleges that Vanguard intentionally caused the unprecedented selloff.

Vanguard is embroiled in a class-action lawsuit over a selloff that investors likened to an “elephant stampede” from its target date funds that left retail investors to take a huge capital gains tax hit.

As the Wall Street Journal reported in January, the selloff involved multimillion-dollar corporate retirement plans getting “out of the standard target funds and into the Institutional equivalents.”

According to the class-action lawsuit, filed Monday in the U.S. District Court for the Eastern District of Pennsylvania, in December 2020, “to cater to retirement plans, Vanguard intentionally caused an unprecedented sell-off from its Retail Funds.”

The suit was filed by retail investors Valerie M. Verduce, Catherine Day and Anthony Pollock, on behalf of the class.

Normally, the lawsuit states, “target date funds don’t sell many assets, so capital gains distributions are minimal. But beginning in December of 2020, Vanguard itself caused an ‘elephant stampede’ sell off” from its retail target date funds.

Specifically, the Journal reported, in the months that followed the December 2020 decision, “plans with $5M-$100M sold their Retail Fund shares and moved to the Institutional Funds. The Retail Funds were forced to sell assets to raise cash to redeem the shares.”

Vanguard chose to open its Institutional Funds (which hold the same assets as the Retail Funds) “to all retirement plans with at least $5M, so that retirement plans invested in the Retail Funds could sell their shares and move over to cheaper, but otherwise identical, Institutional Funds,” the lawsuit states.

This is what happened:

“To raise cash to redeem so many shares, the Retail Funds were forced to sell off as much as 15% of their assets (or even more),” the lawsuit continues. “When these assets were sold, the Retail Funds recognized capital gains on the assets. The resulting capital gains distributions to investors were unprecedented (40 times previous levels).”

This move didn’t hurt retirement plans, but it left taxable investors “holding the tax bag,” the lawsuit says.

Vanguard, the suit states, “had other, readily-available ways to lower costs for retirement plans without hurting its taxable investors. But it either did not even consider these options, or did not care about hurting its smaller, taxable investors. This was a gross violation of Vanguard’s fiduciary duties (among other legal duties).”

Vanguard, the lawsuit states, “competes to get the most assets under management, while maintaining low fees.”

As one of the largest investment companies in the world, with over $8 trillion under management, and “the largest mutual fund provider,” it is “engaged in an ongoing ‘price war’ with its competitors,” the lawsuit continues.

Vanguard is also the largest TDF manager in the industry and the No. 1 “recipient of cash flowing into target-date funds,” the lawsuit continues.

Because most of the money in Vanguard’s target date funds “comes from company and institutional retirement plans,” Vanguard “is therefore incentivized to keep the managers of its retirement plans happy,” according to the complaint.

Before December 2020, “only retirement plans with $100M or more could access the Institutional Funds. Plans with under $100M were limited to the Retail Funds, with higher fees. Naturally, plans with under $100M wanted the lower fees available to the Institutional Fund investors,” the lawsuit says.

Vanguard did not respond to a request for comment by press time.

William Galvin, Massachusetts’ top securities regulator, launched an investigation in late January into the purchase of target date mutual funds by Massachusetts customers in taxable accounts at five broker-dealers — T. Rowe Price Investment Services, American Fund Distributors, BlackRock Investments, Fidelity Brokerage Services and Vanguard Marketing Corp.

Galvin said he was particularly concerned by reports of inadequately disclosed fund changes that shifted financial burdens to small-dollar investors, resulting in large tax bills for those who held the funds in non-retirement accounts.

The Massachusetts Securities Division “is looking at issues like those that recently happened with Vanguard,” a spokesperson for Galvin’s office told ThinkAdvisor then.