By Dr. James M. Dahle, WCI Founder
At the end of 2021, the Vanguard Target Retirement Funds made massive Long Term Capital Gains (LTCG) distributions. This caught a lot of people by surprise. Index funds, like those that make up the Target Retirement Funds at Vanguard, don't generally distribute much in the way of LTCGs. They don't have very high turnover, and most of them have an Exchange Traded Fund (ETF) share class that allows the fund to flush capital gains out without sending them to investors. However, a combination of factors and one seemingly minor event combined to really sock it to investors who valued simplicity over tax efficiency.
Vanguard Target Retirement Funds Are Fine . . . in Tax-Protected Accounts
Target Retirement (TR) Funds are funds of funds that provide a one-stop investing solution. You pick a date near when you want to retire and put all of your money into the fund closest to that date. You forget about it, and the fund manager keeps the various asset classes in balance and, over the years, slowly decreases the aggressiveness of the mix. Easy-peasy.
However, I (and just about everyone else) have long warned that Target Retirement and other “lifecycle” funds were not the most tax-efficient way to invest. If you have both retirement accounts and taxable accounts, this may not be the best option for you. It keeps you from eking out a little extra return using savvy asset location techniques. Whether bonds in taxable or stocks in taxable are right for you, one of them is going to be in the wrong “place” when you use a fund of funds.
But if you're really into simplicity (like Mike Piper at the Oblivious Investor who uses a single Vanguard Life Strategy Fund in all of his accounts), you may be willing to trade a little tax efficiency for the hassle and behavioral benefits of a fund of funds.
However, even I never expected what happened in 2021. Neither did Piper when I asked whether this had given him pause at all about his strategy.
“Admittedly, I didn't see something like this coming,” he said. “But it's just another bullet point under what I (and plenty of other people) have been saying for years: they're not a good fit for taxable accounts.”
Note that while Mike uses a single fund of funds in all of his accounts, he does not have a taxable investing account.
The Vanguard Target Retirement Fund Disaster
As Jason Zweig explained in the Wall Street Journal:
“At the end of 2020, Vanguard reduced the minimum investment in its institutional Target Retirement funds to $5 million from $100 million. That set off an elephant stampede, as multimillion-dollar corporate retirement plans got out of the standard target funds and into the institutional equivalents. (Clients have to sell out of one format to buy the other.)
Last year, assets at Vanguard’s 2035 target fund shrank to $38 billion from $46 billion at year-end 2020; the 2040 fund shriveled to $29 billion from $36 billion. As big clients left, their sales caused the funds to offload some holdings, triggering capital gains—which could be distributed only to the dwindling group of investors who stuck around. Some had made the mistake of owning these funds in taxable accounts.”
Remember, a typical LTCG distribution for the underlying funds in Target Retirements funds such as Total Stock Market Index Fund, Total International Stock Market Index Fund, and Total Bond Market Index Fund is 0%. But for 2021, the distributions were as follows:
As you can see, most of these funds had double-digit capital gains distributions. It was 18% for TR 2040! That fund only made 14.56% in 2021. But investors owning it in taxable now have to pay taxes on 18%, and that doesn't even include dividends and short-term capital gains. The total distribution yield for 2021 was 24%. (It was as high as 27% for the 2015 fund.)
Now, this was no big deal for those who were investing in a Target Retirement fund in their Roth IRA or their 403(b) at work. But for those who were invested in the fund in a taxable account, the results were shocking and costly.
Zweig talks about a redditor called Sitting Hawk:
“[Sitting Hawk] received about $550,000 in distributions in Vanguard’s Target Retirement 2035 fund. So he owes 23.8% in federal tax and 4.95% in Illinois state tax—all told, more than $150,000 . . . He put about $1.9 million into the fund in a taxable account in 2015 after he maxed out contributions to his tax-deferred funds. He added more savings; by last year, he had about $3.6 million in taxable money in the fund.
‘I didn’t want to be that guy who’s constantly trading,' he says. ‘I just wanted to set it and forget it and have some peace of mind instead of messing around with it every couple of days. It sucks that this had to happen. HOW COULD VANGUARD LET THIS HAPPEN?'”
Now that is an extreme situation (and obviously a first-world problem, like most we discuss here on this site). But it does demonstrate just how bad this could be. Imagine getting an extra half-million in taxable income you weren't expecting and didn't need?
Lessons to Learn from Vanguard Capital Gains Distributions in 2021
There are some lessons we can take away from this. Let's go through them one by one.
#1 Funds of Funds Are for Retirement Accounts
The first one I will repeat for those in the back. If you have a taxable investing account, a fund of funds like the Vanguard Target Retirement or Life Strategy funds is not a good choice for you. I'm sorry. This is one of the problems of being wealthy. Mo' money, mo' problems, remember? You'll have to manage (or pay someone else to manage) a more complicated portfolio—or suffer the tax consequences.
Those who held a TR fund in a Roth IRA? No big deal. Vanguard just reinvested the LTCG distributions like the dividend distributions. No tax due. No downside at all.
#2 You Can Get Massive Capital Gains Distributions Without Having Any Capital Gains
Imagine if you had bought TR 2040 in your taxable account in November 2021. You didn't really have much of a return that year, but you still got walloped with the same 18% LTCG distribution. This is the case with many mutual funds. When you buy into a mutual fund, it often already has some embedded capital gains. If a large investor leaves the fund and forces the fund to sell shares of those low-basis securities, you'll be left holding the LTCG bag.
#3 Funds Without ETF Share Classes Are Vulnerable
One wonderful thing about the Vanguard index funds is that they have an Exchange Traded Fund (ETF) share class. When a large investor wants out, they simply pass them the individual securities instead of selling them and giving them cash. So, the remaining investors aren't hurt. Meanwhile, the fund is continually flushing appreciated shares out of the fund, raising the basis, and reducing future tax bills. The ETF unit creation/destruction process improves tax efficiency. In fact, the Vanguard Total Stock Market Fund has not distributed a capital gain in decades. Decades. Zero percent and certainly not 18% in a single year.
The Target Retirement Funds, like most mutual funds, do not have an ETF share class. While it does not matter so much whether you own the Vanguard fund or the Vanguard ETF in taxable for those funds that have both share classes, it certainly does for other mutual funds (Vanguard and non-Vanguard) that do not have both share classes. In those cases, use ETFs preferentially in taxable.
#4 Fund Companies, Even Vanguard, Aren't Always on Your Side
Whether anyone at Vanguard thought about this in advance is not clear, but the company certainly had competing priorities to weigh. It wanted to serve its institutional investors, and it wanted to serve its individual investors. Vanguard wanted to take care of those who invest inside retirement accounts and pensions and those who invest outside of retirement accounts. In this case, Vanguard decided it didn't care about those individual investors who were holding Target Retirement funds in their taxable accounts as much as they did the big institutional investors.
Fund companies, even Vanguard, make decisions like this all the time. Be aware. This problem is simply a consequence of how mutual funds have been taxed ever since the Investment Company Act of 1940. The funds must pass through their capital gains, whether the investors saw gains or not. It's not really fair and I don't think it is good tax policy, but this is how it works. And for some people at the end of 2021, it was awfully costly.
What do you think? Have you ever been hit with a capital gain you weren't expecting? Do you own Target Retirement funds? In taxable? What are you doing to reduce this risk in your life? Comment below!