Folks often ask me what I think about investments called Target Date Funds, or “TDFs” for short. These questions tend to come from those who like to do some of their own research on investing and come across the occasional mention of them online. In the past few weeks, however, these questions have become front and center, mostly due to a lawsuit that was just filed against Vanguard over a couple of its funds. The problems that prompted this lawsuit have to do with some changes Vanguard made to a couple of their TDF funds, which in turn caused some pretty hefty tax bills for many of their retail clients.
You see, a target date fund mixes several different types of stocks, bonds and other investments to help you take more risks when you’re young, and gradually get more conservative in your investment strategy over time. The idea is that with a TDF, you can make an investment in the fund while you’re younger and then “forget about it”. The fund is structured to start with more aggressive investments and then gradually move towards more conservative investments as you near retirement. For example, if you are age 47 now and you plan to retire in the year 2045 at the age of 60, you might choose a TDF with 2045 in its name.
It sounds good in theory, right? Put all of your money in a TDF and you don’t need to think it until retirement? Not so fast. Aside from the typical market risk you are subject to, TDFs have other risks that must be understood.
Some considerations for TDFs include their composition. Not all TDFs with the same target date will have the exact same investment make-up. For example, one retiree may have enough money on hand to invest primarily in bonds and other fixed-income securities. Another, requiring both larger growth and income, may need a greater equity component to keep the portfolio on track. A fund that meets the needs of one of these investors is unlikely to meet the needs of the other.
Additionally, fees and expenses can vary widely among these funds, and many companies that sell TDFs offer only their own funds within the portfolio potentially causing a conflict to objective advice.
But one of the biggest risks they pose? Mistaken asset location. You see, these funds – like any other mutual fund – have tax features that can get pretty messy. Generally, when a mutual fund sells its assets for a profit, it results in a distribution of capital gains to the fund’s shareholders. For this reason, TDFs work best for investors who hold them in a 401(k) or other retirement plan where taxes are deferred. Target funds aren’t managed to minimize dividends or capital gains. Hold them in a taxable account instead of a retirement plan, and you will owe taxes on those payouts—sometimes much more than you would in other types of funds.
So, let’s get back to Vanguard and specifically two types of target-date mutual funds they offer to retail (brokerage) and 401(k) investors. These two Vanguard TDFs had the same investment strategy. But investors needed at least $100 million to access the lowest-cost version of the mutual funds before December 2020. But that month, Vanguard reduced the threshold to $5 million — fueling a mass exit from the higher-cost version. This mass exodus subsequently created big tax bills for some investors in the $5 million target-date funds, amounting to hundreds of millions of dollars according to the lawsuit.
The lawsuit, filed in a Pennsylvania federal court by three investors, claims the investment manager triggered an “elephant stampede” selloff in its TDFs, which led to “enormous” tax bills in 2021 for people who owned the funds in a taxable brokerage account, instead of a tax-advantaged one like a 401(k) plan or individual retirement account. Vanguard, as well as executives and fund trustees, therefore violated their legal duties to investors, the lawsuit claims.
Vanguard’s Target Retirement 2035 and Target Retirement 2040 funds, for example, distributed approximately 15% of their total assets as capital gains—which are taxable outside of retirement accounts. The result was that, basically, the bigger clients who absconded for the lower-fee fund left the “little” investors holding the tax bag.
Unfortunately, Vanguard didn’t have much to say to their individual investors who have taxable money in these funds. Spokeswoman Carolyn Wegemann said that because the Target Retirement approach seeks to reduce risk over time by automatically trimming stock positions, “these funds are best served in a tax-deferred account.”
Hmmmm . . . what about the little guy?
Nowhere on the funds’ main pages at Vanguard.com does the firm tell retail investors that the funds aren’t ideal for taxable accounts. The summary prospectus states on page 10 of 14 that “distributions may be taxable as ordinary income or capital gain.”
It seems to me this could have been largely avoided had investors better understood the tax consequences of owning the fund in a taxable account. This is just another reason to make sure you have a comprehensive retirement system, built by fiduciaries who incorporate quantitative data that supports a downside risk mitigation system. A system that incorporates income, investment, and tax planning built to potentially put you in the highest probability of financial success.
So as always – be vigilant and stay alert, because you deserve more!
Have a great week.
Jeff Cutter offers investment advisory services through Cutter Financial Group, LLC, an SEC Registered Investment Advisor with offices in Falmouth, Duxbury, and Mansfield.
Jeff can be reached at firstname.lastname@example.org. Insurance products, including annuities, are offered through Cutterinsure, Inc., (MA insurance license #2080572). Cutter Financial Group and Cutterinsure are affiliated and under common control but offer services separately. Members of Cutter Financial Group’s management receive revenue directly from Cutterinsure. Any compensation received is separate from and does not offset regular advisory fees. Cutter Financial Group does not charge advisory fees on any insurance products. We do not offer tax or legal advice. Always consult with qualified tax/legal professionals regarding your own situation. Investing in securities involves risk, including possible loss of principal. Insurance product guarantees are backed by the financial strength and claims-paying ability of the issuing company. This article is intended to provide general information. It is not intended to offer or deliver investment advice in any way. Market data and other cited or linked-to content in this article is based on generally available information and is believed to be reliable. Please contact us to request a free copy of Cutter Financials’ Form CRS, Form ADV 2A and applicable Form ADV 2Bs.