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Investors Sue Vanguard After Target Date Funds’ Big Tax Bill

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Three investors are suing Vanguard Group for alleged negligence and breach of fiduciary duty, saying that changes the company made to target date retirement funds resulted in “massive tax bills” for individual investors.

Their lawsuit, which is seeking class action status on behalf of customers who invested in Vanguard’s target retirement funds, is seeking compensation for “hundreds of millions of dollars” in harm to thousands of investors.

A spokeswoman for Vanguard declined to comment.

Vanguard Group Inc

Courtesy of Vanguard

Target-date retirement funds are popular low-cost savings vehicles for investors seeking a one-stop shop for retirement assets. The funds contain a mix of stocks and bonds and are tied to a date, such as 2035, when the investor anticipates retirement. As the fund approaches its target date, it gradually allocates more assets to fixed-income rather than equities.

Approximately $1.8 trillion was invested in target date mutual funds as of June 30, 2021, according to the Investment Company Institute.

The investors’ lawsuit, which was filed March 14 in a federal court in Philadelphia, stems from changes Vanguard made in late 2020.

The asset manager–one of the world’s largest with $8.1 trillion in total assets under management as of Jan. 31–had two tiers of target date funds, one for individual investors and retirement plans with fewer than $5 million and one for institutional investors with more than $100 million, according to the lawsuit. Both tiers used the same strategy and investments, but institutional investors paid a lower fee.

In December 2020, Vanguard lowered its minimum for institutional investors to $5 million.

That change sparked a sell-off in the retail target funds as smaller retirement plans sold assets in order to shift money into lower cost institutional funds, according to the lawsuit. Vanguard’s retail funds sold as much as 15% of their assets to raise cash to redeem shares, and in doing so realized capital gains which were distributed to the funds’ remaining investors as required by law, according to the lawsuit.

“While this didn’t hurt retirement plans, it left taxable investors holding the tax bag,” the lawsuit states.

Individual fund investors were hit with capital gains distributions at least 40 times larger than ever before, according to the lawsuit.

Vanguard had other options to avoid this outcome such as lowering the retail fund fees for plans that had at least $5 million invested or merging the two funds together, according to the lawsuit.

Ultimately, Vanguard did the latter, merging the funds together in September 2021. This had no tax consequences for investors, according to the lawsuit. “At this point, however, the harm was done. Taxable investors had already incurred unnecessary capital gains distributions–and corresponding taxes–that could not be erased.”

The lawsuit’s three plaintiffs–Valerie Verduce of Georgia, Catherine Day of Massachusetts, and Anthony Pollock of California–invested in Vanguard funds in taxable accounts, according to their legal complaint. The three plaintiffs received more than $240,000 in combined capital gains in 2021 and they estimate their combined tax liabilities will be more than $55,000, according to the lawsuit.

Write to Andrew Welsch at andrew.welsch@barrons.com

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