Suit against Vanguard focuses on big tax bills for target-date funds

Vanguard was forced to sell as much as 15% of the assets in retail target-date funds, resulting in substantial capital gains taxes for investors who held the funds in taxable accounts, the lawsuit asserts.

Investors in Vanguard target-date retirement funds are suing the company for allegedly mismanaging the accounts and causing them to be hit with excessive tax bills.

In a class-action lawsuit filed Monday in U.S. District Court for the Eastern District of Pennsylvania, the plaintiffs focus on Vanguard’s sale of a large amount of assets from their accounts in December 2020 to redeem shares that moved from Vanguard’s retail target-date accounts to its institutional accounts.

The migration was caused by Vanguard’s decision to open its institutional funds to all retirement funds with at least $5 million in assets, down from a previous $100 million threshold. Reducing the bar for the lower-fee institutional funds caused an “elephant stampede” out of retail funds, according to a Wall Street Journal story.

Vanguard was forced to sell as much as 15% of the assets in retail target-date funds, resulting in substantial capital gains taxes for investors who held the funds in taxable accounts, the lawsuit asserts.

“The resulting capital gains distributions to investors were unprecedented (40 times previous levels),” the suit states. “While this didn’t hurt retirement plans, it left taxable investors holding the tax bag.”

The suit names three plaintiffs — Valerie M. Verduce of Georgia, Catherine Day of Massachusetts and Anthony Pollock of California — who held Vanguard retail target-date funds in taxable accounts and had tax liabilities of $9,000, $12,000 and $36,000, respectively. The suit says the harm across all retail investors in taxable accounts could amount to hundreds of millions of dollars or more.

“The complaint explains how Vanguard hurt its smaller, taxable investors, so that it could favor its larger retirement plans,” Jonas Jacobson, a partner at Dovel & Luner and counsel for the plaintiffs, said in a statement.

A Vanguard spokesperson declined to comment.

Unlike most lawsuits against retirement funds, this one is based on the tax consequences of a fund’s actions rather than its record-keeping fees or conflicts of interest in investment selection.

Vanguard’s retail and institutional target-date funds pursued similar investment strategies using different versions of the same index funds. The retail index funds had higher fees than their institutional counterparts.

When Vanguard decided to lower the asset threshold from $100 million to $5 million for retirement plans to invest in the institutional target-date funds, Vanguard didn’t consider the consequences for investors in taxable accounts, said Daniel Wiener, chairman of Adviser Investments.

“This is a major-league screw-up of epic proportions,” Wiener said. “It’s just bad thinking.”

Vanguard should have been using the lower-cost index funds in its retail accounts, he said.

“Had they done that, there wouldn’t have been as big a difference in costs, forcing people to move from retail to institutional,” Wiener said.

Vanguard has developed a reputation for offering low-cost investment products to ordinary investors, a theme established by the firm’s iconic founder, the late John Bogle. The complaint quotes Bogle about his belief in treating investors fairly.

“Over its history, Vanguard has often lived up to that purpose,” the complaint states. “It has become one of the most respected and successful investment companies in the world. But in this case, it has fallen far short. It harmed its smaller, taxable investors (the very people it was founded to serve) to cater to the retirement plans that drive its bottom line.”