Vanguard may have to raise fees!

Strange case. I wonder, though, if Vanguard's structure is to be owned by the investors, then can't it be said, in *some* sense, that the higher returns brought about by lower fees *are* the profit that Vanguard's owners are receiving? Then again, I'm not a lawyer.
 
Interesting legal issues, for sure.

It seems to this non-lawyer that the root issue is an at-cost internal transaction where the branch of the company that runs and services Vanguard mutual funds - the management company - "pays" another branch that advises on the management company's purchase and allocation of the investments in its mutual funds.

The numbers in the article suggest that the advisory branch charging zero profit rather than a fee that includes an 8 basis points open market rate profit violates the arms length rules. I suppose this results in an alleged dodge of perhaps 4 basis points in taxes (at a 50% corporate tax rate).

Two thoughts...

I wonder if the 8 basis points number the author uses is based on either 1) an industry average profit for advising managed funds or 2) average profits for advising the whole universe of mutual finds, including both managed funds and index funds. Either way, I would think that a calculation of Vanguard's "market rate" for arm's length advisory expenses would be substantially less than an industry average based on any comparison set that includes actively manged funds. I believe Vanguard has a much higher proportion of funds invested in index funds than the most mutual fund providers. Even if Vanguard loses on the legal point, demonstrating that the market-based fee of "advising" an S&P index fund to buy 500 stocks is lower than a comparable managed fund would no doubt be part of the settlement discussion.

It also would seem that Vanguard could spin off the internal advisory function as a low-profit independent advisory company to eliminate the alleged tax issue for the internal transaction. I didn't see anywhere in the article that running either the Vanguard management operation or the Vanguard advisory operation at near-zero profit is the problem. Having them under one roof is the alleged issue.

In any case, the total potential impact to me appears to be just a few basis points, so I'm not too concerned.
 
With the settlement to Texas, and California hot on the heels of Vanguard, I'm understanding recent cost-cutting moves. I was not aware that executive salaries are hidden.

When this issue first surfaced (2014?), the descriptions I read made it seem like it had merit. However, most disagree I'm sure.
 
Perhaps Vanguard's owners should organize a visit-your-Congressperson campaign. If other exemptions are already carved out, then carve out those entities that are investor-owned like Vanguard. Absent some lobbying, we are likely to take a hit. ER.org and Bogleheads unite!
 
target2019 said:
With the settlement to Texas, and California hot on the heels of Vanguard, I'm understanding recent cost-cutting moves........
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When I read the article the same thought occurred to me. Wondered if this was at least partially behind the decision to drop the TurboTax discount/giveaway.
 
Maybe they will just re-organize as a firm based in Ireland and all the future tax issues will go away.

This is not unexpected. Cities and States need money. This is one more way to get it.
 
Looking4Ward said:
When I read the article the same thought occurred to me. Wondered if this was at least partially behind the decision to drop the TurboTax discount/giveaway.
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The corporate tax issues are all way beyond my limited understanding. But I see a scenario where Vanguard has grown quite a bit, and is now a large target. With anti-financial sentiment so high, I think this will turn out not so well for Vanguard and its owners (like me). I don't foresee Congress cutting them a deal at this time.

Thanks to Htown for explaining the investment management company. I think that point is not evident in the original article.
 
target2019 said:
Thanks to Htown for explaining the investment management company. I think that point is not evident in the original article.
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You are assuming my reasoning is correct, but thanks. :)

I'm no expert - just an interested bystander trying to make sense of a complicated legal question from this one article. I look forward to hearing from others who may bring tax code knowledge or more in-depth information from other sources.

In the meantime, I must get back to drafting my letter to the Vanguard CEO offering my services for independent advice on the asset allocation for the VFINX S&P 500 fund. I'm stuck on whether to charge 0.00001% or 0.00002%.;)
 
Your instincts are in line with mine. The zeitgeist is very "Harrison Bergeron" these days - let's "equalize" everyone, not by expecting more from those who do little, but by taking from those who have accumulated more.

https://en.wikipedia.org/wiki/Harrison_Bergeron

target2019 said:
The corporate tax issues are all way beyond my limited understanding. But I see a scenario where Vanguard has grown quite a bit, and is now a large target. With anti-financial sentiment so high, I think this will turn out not so well for Vanguard and its owners (like me). I don't foresee Congress cutting them a deal at this time.

Thanks to Htown for explaining the investment management company. I think that point is not evident in the original article.
Click to expand...
 
Travelwanted said:
Yes, I think that is coming. Bogleheads.org has a thread also:
https://www.bogleheads.org/forum/viewtopic.php?f=10&t=178883&newpost=2707747
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Yeah, an earlier relevant thread over there began well over a year ago and has over 600 posts: https://www.bogleheads.org/forum/viewtopic.php?f=10&t=143686 Note that (as discussed there) the New York case brought by this particular guy was thrown out because he breached his duties as an attorney by disclosing his former client/employer's information in the lawsuit. The tax issues remain alive though.
 
target2019 said:
The corporate tax issues are all way beyond my limited understanding. But I see a scenario where Vanguard has grown quite a bit, and is now a large target. With anti-financial sentiment so high, I think this will turn out not so well for Vanguard and its owners (like me). I don't foresee Congress cutting them a deal at this time.

Thanks to Htown for explaining the investment management company. I think that point is not evident in the original article.
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This. They aren't liked by many folks (except folks like us, of course!). They have marks on them from the feds, the "Wall Street Sucks" crowd and the worst, all the large financial "services" corporations that VG has been sucking away over the last few years.

Oh yeah, I wonder if Danon (the whistleblower tax atty that is getting some decent $$$ for whistleblower bounties) is going to invest that money with Edward Jones? ;)
 
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It is interesting on what actually happens in a real company...

I worked for a huge mega that had operations all over the world... I spent a few years doing internal service allocations...

When we did the allocation, we did not calculate a profit on the corporate services... it was allocated at cost... so, not trying to hide profits in a tax free location...

But, there was a small sub that did work for the large corp... and when they did their allocation they put in a 5% profit... maybe they were doing it correctly...

I have no idea how the tax dept handled any of the entries... tax and book can be wildly different....
 
It's also not the first time that large for profit corporations and those doing their bidding have attacked a lower cost, not-for-profit provider as being "anticompetitive" and possessing an unfair advantage because they don't need to generate profits or ROI for shareholders.
 
What does this mean to us, owners of Vg mutual funds?

If Vg is forced to raise fees, we could move our funds. However, with Vg having higher fees, a big incentive for other companies to keep their fees as low as possible is removed. On the other hand, other companies are beginning to get close to Vg's fee structure & iirc, there is one S&P500 ETF that charges less than Vg.

Then there is the forced realization of capital gains if we have to change mutual funds. To me, that's a big one.

I guess it is too early, and there are too many variables and unknowns to determine the best course of action.
 
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Less profit for Vanguard means higher taxable gains for us the shareholders. More taxable profits for Vanguard means lower taxable gains for the shareholders. As far as I know, other corporate structures allow this kind of profit pass through to shareholders. Either way, the taxing authorities already get their pound of flesh IMO. Corporations have many ways to avoid taxation (hey Vanguard already has operations in Ireland, a move might be in order!) so shifting the tax burden to the corporation might not yield higher tax revenues in the long term.
 
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As I understand it the argument is that Vanguard charges its funds "cost" rather than "fair market" fees and expenses, and as a result doesn't make profits and doesn't pay taxes.

While it is true that Vanguard's ERs are less than average, their ERs are in the ball park with the larger and more competitive funds, so any complaint based on a charge that they are not charging a market fee is questionable since Fidelity and other other big players have similar ERs for similar funds.

In any event, it'll be in litigation and appeals for many years... probably longer than I'll be around. I don't see any big change in the near future.

FWIW, the guy lost the first round:
Last month, a New York judge ruled that Danon could not sue to collect whistle-blower fees there because, as a New York lawyer, he would have violated confidentiality restrictions in reporting alleged wrongdoing to the state in early 2013 before Vanguard fired him. Danon plans to appeal.

Read more at http://www.philly.com/philly/busine...ons_against_Vanguard.html#Ciq5XlUWBZbEdODJ.99
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pb4uski said:
As I understand it the argument is that Vanguard charges its funds "cost" rather than "fair market" fees and expenses, and as a result doesn't make profits and doesn't pay taxes.

While it is true that Vanguard's ERs are less than average, their ERs are in the ball park with the larger and more competitive funds, so any complaint based on a charge that they are not charging a market fee is questionable since Fidelity and other other big players have similar ERs for similar funds.

In any event, it'll be in litigation and appeals for many years... probably longer than I'll be around. I don't see any big change in the near future.

FWIW, the guy lost the first round:
Click to expand...


The other thing is that who will get that profit? From what they say, the investors 'own' Vanguard.... so, if Vanguard made a profit, would it not have to send that profit to the investors?


From the little I know, a mutual insurance company sends checks to policy holders if they collected more in premiums than paid out in claims... but I could be way off on this... just do not know for sure.
 
I think the issue is that 35 cents of every $1 of profit would go to taxes and the remaining 65 cents would go back to fundholders.

So for example, if today the cost and charge are 30 and a fair value charge would be 100, under what some argue the fund manager would have a profit of 70, pay 25 in tax and push 45 back to the fundholders.... so net the fundholders would pay 55 (100-45) rather than 30.

The difference with a mutual insurer is that the mutual insurer is a single company so the tax issue doesn't exist... in this case the funds are separate legal entities that "own" the manager which is a separate legal entity but can't file a consolidated tax return. I seem to have a faint recollection that the structure passed muster with the IRS as some point but I don't recall the details.
 
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pb4uski said:
As I understand it the argument is that Vanguard charges its funds "cost" rather than "fair market" fees and expenses, and as a result doesn't make profits and doesn't pay taxes.

While it is true that Vanguard's ERs are less than average, their ERs are in the ball park with the larger and more competitive funds, so any complaint based on a charge that they are not charging a market fee is questionable since Fidelity and other other big players have similar ERs for similar funds...
Click to expand...

Interesting angle that might actually work. Problem is, Vanguard Group intentionally charges their funds at cost. It will be near impossible to argue that transacting at cost meets the "arm's length" standard of section 482. That's not how rational unrelated parties behave.

Plus, if the cost (with tax advantage) is "close" to fair market, that seems to suggest that the underlying economics at Vanguard are less advantageous than it appears, just judging from fund ERs. From the article:

Raising fees to cover those taxes could require quadrupling its average fee, according to Avi-Yonah, who is working with Danon on this issue.
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Probably biased, since it came from someone working with Danon. But still, if that's even half accurate, it would put Vanguard at a severe disadvantage.

pb4uski said:
In any event, it'll be in litigation and appeals for many years... probably longer than I'll be around. I don't see any big change in the near future...
Click to expand...

You're probably right. But evidently, Vanguard is now paying taxes, penalties, and interest based on Danon's disclosures. That's a significant development from last time I read about this issue, which could motivate other states and the IRS to move quicker and more aggressively.
 
Texas Proud said:
The other thing is that who will get that profit? From what they say, the investors 'own' Vanguard.... so, if Vanguard made a profit, would it not have to send that profit to the investors?...
Click to expand...

pb4uski said:
I think the issue is that 35 cents of every $1 of profit would go to taxes and the remaining 63 cents would go back to fundholders.

So for example, if today the cost and charge are 30 and a fair value charge would be 100, under what some argue the fund manager would have a profit of 70, pay 25 in tax and push 45 back to the fundholders.... so net the fundholders would pay 55 (100-45) rather than 30....
Click to expand...

Agreed. Good example. The net effect to investors (higher ER minus distribution of after-tax profit) would be the same EXCEPT for the new tax that was paid. Seems to me, the only real difference is that tax gets paid sooner and probably at a higher rate (i.e., as Vanguard Group provides services to funds) rather than later (as investors or their heirs sell fund shares to generate spendable cash). All fine and good for the IRS. Not so much for you and me.
 
pb4uski said:
I think the issue is that 35 cents of every $1 of profit would go to taxes and the remaining 65 cents would go back to fundholders.

So for example, if today the cost and charge are 30 and a fair value charge would be 100, under what some argue the fund manager would have a profit of 70, pay 25 in tax and push 45 back to the fundholders.... so net the fundholders would pay 55 (100-45) rather than 30.

The difference with a mutual insurer is that the mutual insurer is a single company so the tax issue doesn't exist... in this case the funds are separate legal entities that "own" the manager which is a separate legal entity but can't file a consolidated tax return. I seem to have a faint recollection that the structure passed muster with the IRS as some point but I don't recall the details.
Click to expand...

Are the mutual funds a single company? As I said, I do not know...

But I do know that AIG has plenty of different legal entities.... I also know that Progressive does too... they are not mutual insurance, but just giving out a couple of examples on the for profit insurance companies....
 
Yes, the mutual funds that you buy shares of are separate legal entities from the fund manager, fund administrator and fund marketer. The mutual fund is owned by us (the mutual fund shareholders) and has contracts with the fund manager, fund administrator fund marketer to provide investment management, fund administration and marketing services, respectively, to the mutual fund and in most cases are under common control and owned by the common control group's shareholders (like Fidelity).

Commonly, the fund manager, fund administrator and fund marketer are said to "sponsor" the mutual fund in that they set it up, provide seed money for it, do the marketing, etc. In theory, a mutual fund board could "fire" the manager and it has happened but is exceedingly rare because usually the mutual fund board is nominated by the fund administrator (talk about incestuous).
 
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