Vanguard to Pay Massachusetts Investors Millions Over Target-Date Fund Tax Hit

Target-date funds have become a default choice in many retirement plans and are popular with investors looking for low fees and a hands-off approach to investing. Investors can select a fund that roughly corresponds to their expected retirement date. Over time, the fund shifts its allocation from mostly equities to a more balanced mix of stocks and bonds.

Assets in target-date funds grew to $3.27 trillion at the end of 2021, up from $2.8 trillion at the end of 2020, according to a report from research firm Morningstar.

Vanguard offered two versions of its target-date funds—one for retail investors and one for institutional clients. Both used the same strategy and investments, but institutional investors paid a lower fee. In December 2020, Vanguard announced it was reducing investment minimums for institutional TDFs to $5 million from $100 million. That prompted a number of small retirement plans to shift assets from retail to the institutional TDFs—an exodus that forced the retail TDFs to sell assets, creating capital gains for investors who held the funds in taxable accounts.

Long- and short-term capital gains were distributed to over 5,000 Massachusetts accounts, according to Secretary of the Commonwealth William F. Galvin, who oversees the state’s Securities Division. The agency said Vanguard marketed its target-date funds as a hands-off investment option for hard-earned retirement savings

Most of the settlement money—$5.5 million—will go to eligible Massachusetts investors to cover the tax liabilities that they incurred as a result of capital gains distributions, according to the Massachusetts regulator. Vanguard will also make a one-time payment of $500,000 to the Commonwealth of Massachusetts.

“I’m pleased that my office has been able to secure meaningful relief for Massachusetts investors,” Galvin said in a statement. “These extraordinary capital gains were caused by Vanguard’s conscious decision to benefit ultra-wealthy shareholders over main street investors.”

Vanguard did not admit or deny any wrongdoing as part of the settlement.

“We are glad to put this matter behind us and avoid the cost and distraction of a protracted process,” a company spokeswoman said in a statement. “As a client-owned organization, Vanguard has a long history of lowering costs and investment minimums to benefit investors and retirement savers. We remain committed to reducing the cost and complexity of investing to help more Americans reach their financial goals.”

Vanguard is one of the world’s largest asset managers. Known for its low-cost funds, the company serves more than 30 million investors and oversees more than $8 trillion in assets.

The investors suing Vanguard are seeking class-action status on behalf of themselves and other Vanguard customers who invested in the company’s target-date funds. 

The lawsuit says that as a result of the selloff prompted by Vanguard’s new investment minimums, the company’s retail funds sold as much as 15% of their assets to raise cash to redeem shares. In doing so, the funds realized capital gains that 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,” according to the lawsuit filed March 14 in a federal court in Philadelphia. The case is pending.

Vanguard allegedly had other options, 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 merged the funds together in September 2021. This had no tax consequences for investors, according to the lawsuit. 

The Secretary of the Commonwealth said that it had begun investigating the issue in January and that it plans to inform eligible investors in Massachusetts that they may be entitled to financial restitution from Vanguard. Massachusetts has one of the more aggressive state securities regulators. For instance, the agency recently pressed brokerages as to when they intended to raise yields on clients’ cash accounts. Last year, it fined a unit of MassMutual $4 million for allegedly failing to supervise the social media activity of its employees, including Keith Gill, who became famous for his YouTube videos discussing meme stocks. The Secretary of the Commonwealth also attempted to enact a fiduciary rule requiring brokers to act in clients’ best interests; a state judge vacated the rule in March after Robinhood Financial sued the regulator.

Write to Andrew Welsch at [email protected]