A class action lawsuit filed yesterday against Vanguard Group and more than a dozen fund trustees claimed that they failed in their fiduciary duty to some of their retail target-date fund investors after a policy change triggered fund sales that caused “unprecedented” levels of recognized capital gains, the complaint said.
The complaint, filed in U.S. District Court, Eastern District of Pennsylvania, alleged breach of fiduciary duty, gross negligence, breach of the covenant of good faith and fair dealing, unjust enrichment and violation of the California Unfair Competition Law.
Officials at Vanguard declined to comment.
According to the complaint, Vanguard historically offered two kinds of target date funds: the retail funds, which were for individuals and retirement plans with less than $100 million in assets, and the institutional funds, which were for retirement plans with more than $100 million in assets. While the strategy and investments were the same, the fees charged to the institutional investors were lower than those charged to the retail investors.
Target date funds are broadly portrayed as "set-it-and-forget-it" funds and they have been touted by the mutual fund industry, as well as consumer advocates, as a sound solution for mainstream Americans lacking investment sophistication. Skeptics have criticized this one- size-fits-all approach but other issues surrounding investing protocols appear to lie at the heart of the complaint.
Beginning in December 2020, Vanguard opened its institutional funds to retirement plans with more than $5 million, causing many to make the switch from the retail side to the institutional side in order to pay lower fees, the complaint said.
When a target date fund sells assets, it distributes any capital gains to shareholders. Investors with tax-advantaged accounts usually reinvest those distributions without incurring any tax liability. But investors with taxable accounts have to pay taxes on the distributions, even if they automatically reinvest them.
According to the complaint, Vanguard and its trustees knowingly caused a tsunami of outflows from the retail funds to the institutional funds. For example, assets in the 2035 retail fund dropped to $38 billion from $46 billion, and assets in the 2040 fund fell to $29 billion from $36 billion, the complaint noted.
“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). When these assets were sold, the Retail Funds recognized capital gains on the assets,” the complaint said. “The resulting capital gains distributions to investors were unprecedented (40 times previous levels). While this didn’t hurt retirement plans, it left taxable investors holding the tax bag.”
Three individual investors who allegedly had been harmed by Vanguard’s decision were named in the complaint.