Vanguard Target Date Fund Throws Off Massive Capital Gains Taxes

Why investors who were blindsided and now suing the firm

I want to ask you a question. Do you have a target date fund? I hate these things, but they are hugely popular. And now it looks like Vanguard really messed up with one of their target date funds. And now they're getting sued for gross negligence, breach of fiduciary duty, unjust enrichment, and breach of good faith and fair dealing. Well, here's what happened. Vanguard had two target date funds for the sake of this conversation. One of them was for big institutional investors, pension plans and 401k plans with billions of dollars in assets. Another target date fund was for individual investors and for small 401k plans. To invest in that institutional fund, you had to invest at least $100 million. The fee was less than the retail fund. It kind of makes sense, right? You invest a huge amount of money, you pay less. Okay, that's not unusual. 

But here's the deal. At the end of 2020, Vanguard changed the account minimum for the institutional fund. Instead of having to invest $100 million, Vanguard lowered it to just $5 million. So all those small 401k plans that were in the retail fund sold their shares and they move their money over to the institutional fund, which is cheaper. The two funds are identical except for the fee. So by making this shift, these small 401(k) plans got to save money by moving over to the larger institutional fund. This was very nice of Vanguard to let them do this.

It saved all those little 401(k) plans money. Great. But so many of these small 401(k)s sold their shares out of the retail fund. Then Vanguard had to sell 15% of the fund's assets to raise the cash to send it over to the institutional fund. And selling all those shares triggered huge capital gains. Now, this didn't matter to the 401k plans because they don't pay taxes. But it sure matters to all of the ordinary retail investors who are also in that fund. They got hit with massive, unprecedented capital gains distributions 40 times more than ever before, and they got no notice that this was happening until they got their IRS Form 1099 in the mail early the next year. 

So now three of those investors are suing Vanguard and they're seeking hundreds of millions of dollars in compensation on behalf of all the investors. These three say their tax liabilities are $55,000 just for the three of them. Imagine the tax hit for everybody else who owns those shares. Everyone on Wall Street is shaking their head, trying to figure out why did Vanguard handle this the way that they did? It's going to be really interesting to see how this lawsuit plays out. And in the meantime, I just got another reason to hate target date funds.