The largest target-date fund manager in the retirement industry and the No. 1 recipient of cash flowing into target-date funds is now the subject of a lawsuit brought by a class of its retail investors.
The proposed class action, Verduce et al. v. Vanguard Chester Funds et al., alleges The Vanguard Group and its top officers and trustees harmed retail taxable investors financially when the firm caused an “elephant stampede” sell-off of the assets of certain target-date funds in December 2020.
The 28-page suit, filed Monday in Philadelphia federal court, says that after Vanguard opened its lower-fee institutional target-date funds—typically used by $100 million-plus retirement plans—to all retirement plans with at least $5 million in assets, its retail target-date funds—typically used by individuals and retirement plans with less than $100 million—were forced to sell off as much as 15% of their assets to raise the cash needed to move over to the less expensive, but otherwise identical, institutional funds.
“The complaint explains how Vanguard hurt its smaller, taxable investors, so that it could favor its larger retirement plans. These injured investors deserve to be made whole,” Jonas Jacobson, Dovel & Luner LLP (counsel for the plaintiffs), told 401k Specialist Tuesday.
A Vanguard spokesperson declined to comment on the suit.
On Dec. 11, 2020, Vanguard announced it was broadening access to Vanguard Institutional Target Retirement Funds (TRFs) by reducing the plan-level minimum investment requirement to $5 million from $100 million, saying the move enables “more 401k and 403b plan sponsors to offer these low-cost, broadly diversified options to their retirement plan participants.”
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 complaint states.
“The problem was that, if Vanguard opened up the Institutional Funds to these plans, it would trigger a massive sell-off in the Retail Funds, as plans sold their assets to move them over,” the complaint continues. “To get cash to redeem shares, the Retail Funds would have to sell a substantial portion of their assets. In doing so, the Retail Funds would realize capital gains on any assets they sold that had appreciated in value.”
The complaint alleges Vanguard had some readily available options to avoid causing this problem, including to:
• Lower the Retail Fund fees for plans that had at least $5M invested. “This could be done by restructuring share classes, reclassifying shares, or other readily available means. Such fee-tiering is commonly done by mutual funds (including Vanguard funds). This would reward retirement plans, with no adverse tax consequences for smaller, taxable investors.”
• Merge the Retail and Institutional Funds. Importantly, such a merger could be completed without tax consequences for any shareholders. Vanguard could then adjust or tier the fees in the merged fund. Notably, Vanguard decided to merge the Retail and Institutional Funds in September 2021.
The complaint says that instead of these two options, Vanguard chose at the time to drop the Institutional Fund investment minimums, triggering the massive sell-off. As The Wall Street Journal described in a Jan. 21, 2022 article, that “set off an elephant stampede, as multimillion-dollar corporate retirement plans got out of the standard target funds and into the Institutional equivalents.”
For tax-advantaged retirement plans, the complaint says the large distributions were harmless as they simply reinvested the cash, without taking any tax hit. But for smaller, taxable investors, these distributions meant enormous tax bills (tens of thousands or even hundreds of thousands of dollars).
“This was a gross violation of Vanguard’s fiduciary duties,” the complaint claims. “The decision to drop the Institutional Fund investment minimums—as opposed to taking other actions that lowered fees for retirement plans without triggering a massive sell-off in Retail Funds—violated this duty.”
The lawsuit looks to represent all U.S. investors in Vanguard’s retail funds who held these funds in taxable accounts and who received 2021 capital gains distributions.
Within weeks of Vanguard’s Dec. 2020 decision to lower the investment minimum, Fidelity Investments mirrored the move in announcing that effective January 19, 2021, it lowered the investment minimum for the Institutional Premium Class of the Fidelity Freedom Index Funds by 95%: from $100 million to $5 million.
By expanding access to the low-cost share class, Fidelity said at the time the move enables “retirement plan sponsors and other fiduciaries to offer their plan participants even greater value.”
SEE ALSO:
• Fidelity Matches Vanguard Move to Lower Investment Minimum for Institutional TDFs
• Vanguard Enhances its Target Retirement Series
Veteran financial services industry journalist Brian Anderson joined 401(k) Specialist as Managing Editor in January 2019. He has led editorial content for a variety of well-known properties including Insurance Forums, Life Insurance Selling, National Underwriter Life & Health, and Senior Market Advisor. He has always maintained a focus on providing readers with timely, useful information intended to help them build their business.
Without knowing exactly how the change was made to move clients from the investor share class to the institutional share class, I find it hard to believe that based on historical patterns for share class conversions at Vanguard that they did not use their pre-established process, Share class conversions at Vanguard historically have not been taxable events based on how they have lowered their minimums for their Admiral Share and Institutional Share Classes. Vanguard has decades of history of lowering the minimums for their share classes such as when they lowered the Admiral Share Class from $250,000 down to $50,000 and then again when they lowered it from $50,000 to $10,000. It will be interesting to see how this case plays out but I highly doubt the plaintiff will win in this case because it’s a stretch to connect the capital gains to the share class conversion. I would also challenge the suitability of investing in TDFs in non-retirement accounts.