Just as it is easy for me to talk about dividend investing because real-life companies like Coca-Cola and Colgate-Palmolive exist, it is easy to advocate index fund investing because Vanguard exists. You can write a check or establish an electronic debit for $3,000 of VFINX, and instantly own shares in the 502 different companies that currently represent the S&P 500. And you only have to pay 0.17% in annual fees. Between 2015 and 2025, you will only pay an estimated $119 in total fees in exchange for using Vanguard’s consolidated purchasing power to buy ownership stakes in a wild diversity of companies.
Vanguard’s low fees enable people to get near market returns over the long run for just a $3,000 initial investment, and it is a great tribute to John Bogle’s legacy that he has been able to assist Americans of ordinary income in their quest to build a retirement nest egg or achieve financial independence at an early age.
But there is a small subsection of Vanguard clients that are eventually going to blame the firm for ruining their financial lives. It involves Vanguard’s disastrous policy concerning succession plans for individuals that own multiple IRAs of the same type and plan to make non-spousal inheritance for multiple people on each account.
If you visit the top of page 20 on Vanguard’s Custodial Agreement (I attached a link at the bottom of this post), you will see that Vanguard reserves the right to change its custodial agreements at any time. The only limitation is that Vanguard must provide notice of the change to you in writing, and then you receive thirty days to object and find some kind of resolution.
In July of 2007, Vanguard took advantage of its ability to amend custodial IRA arrangements and notified its IRA clients that IRAs of the same type can no longer have different beneficiaries, and if they do, Vanguard will choose the most recent IRA beneficiary form filed with the company as the basis for determining succession.
Most people may have a consolidated IRA that chooses different beneficiaries. Such accounts are not affected by this change. If you own a Roth IRA that has $300,000 in the account, and you choose to have a third go to Molly, Sarah, and Michael, there is no issue. Each of them will get $100,000, minus the distribution and potential termination of account fees.
The issue is if you have two separate accounts of the same type that have different beneficiaries. Imagine if worked as an advertising executive for Anheuser-Busch in the 1990s. You built up a $250,000 traditional IRA portfolio through Vanguard consisting primarily of oil stocks. One of your two sons works at Schlumberger, and has been playing with Total SA tanker cars since he was a kid. Trying to be poetic at your time of death, you fill out a beneficiary form that gives the entirety of this traditional IRA to your oil employee son because it will increase the sentimental value of your legacy when he thinks of you as he cashes a $3,000 oil dividend from Royal Dutch Shell.
The reason why you felt comfortable giving it all to one son is because you built another traditional IRA between 1999 and 2006 that consists primarily of index funds. He doesn’t carry about the style or the process of wealth—he just wants the $250,000. You direct this traditional IRA through Vanguard to go entirely to your second son.
When the time of your death arrives, you leave the earth thing you’ve left each child $250,000. Wrong. Because you received that Vanguard letter in 2007 and didn’t do anything about it, you fell victim to the new terms that give singular types of IRAs to the arrangement on your most recently filed form. Because the 100% inheritance to the index fund son was the most recent document filed, he is also legally entitled to the $250,000 in oil stocks from the previous IRA. The first son gets nothing, despite that unchanged beneficiary form claiming that he gets 100% of the estate.
Again, I should reiterate that this only applies to accounts of the same type. If you open a traditional IRA in 1998 through Vanguard with a different set of beneficiaries from a Roth IRA, you are fine. Roth IRAs and traditional IRAs are considering different types of accounts for Vanguard’s calculation purposes. And if a singular IRA has a different assignment of beneficiaries—30% for Kid 1, 30% for Kid 2, and 40% for Kid 3, that will also be honored.
The issue is when you have distinctly different accounts of the same type with different beneficiary arrangements. You could work at a primary job for 30 years, build a $2.5 million traditional IRA to give to your children, and then create a $25,000 traditional IRA in 2004 while working at the local library in semi-retirement that you could send to your favorite charity of choice. In your mind, you think you’re creating IRA accounts that mirror your employment symmetrically. You could think you’re leaving the bulk of your estate to your kids, with a bit going to charity, but that is not true. You are leaving a $2,525,000 to your favorite charity.
When I called Vanguard to inquire about this policy, a Vanguard employee told me that the company has to keep costs low to become the market leader for customers, and did not have the capacity to entertain “exotic” account requests. She stressed that this is not something that is an issue today.
I don’t see it that way.
I understand Vanguard’s desire to keep costs low. But you have to know the right places to be frugal. If you have an account balance less than $10,000 with Vanguard, your account is charged an annual fee of $20 unless you choose to accept all electronic statement correspondence. You may not like that policy, but it is an understandable way to keep costs low so that the expense ratio can stay around 0.2%. The world is not going to stop turning if you get hit with an unexpected $20 annual fee.
But your world will stop turning if you expect a $500,000 inheritance, your loved one tells you that you are to receive a $500,000 inheritance, but Vanguard created its own procedural rules that violate your intent. They do it in the name of saving fees, but it seems that Vanguard is taking to editorializing about what they think is best for you rather than acting as a custodian.
There comes a time when your job is to execute the plans of others and not try to override them with your own judgment. If you are an estate attorney and a client wants to create a will that doesn’t give equal money to each kid, it’s wise to point out the consequences of the strategy. But once the client says that’s what he wants to do, you execute it. You don’t get to tell them how to write the story of their lives.
What Vanguard is saying that they think it is weird, foolish, stupid, or whatever to create multiple IRAs of the same type with different beneficiary arrangements. They don’t condone giving a $500,000 IRA to Child 1 and then giving $50,000 to a child resulting from a second marriage. They don’t like the social policy behind unequal distributions of estates, and that is why they are choosing to cut costs here. Certainly, if they though there was public policy value behind this type of IRA arrangement, they would not aim to save administrative costs in this field.
The issue is that people are being blindsided. The 2007 mailer from Vanguard was titled “Change in Beneficiary Policy will help you simplify your planning.” You know what people do with generic mailings? They throw them away. There is nothing from the title of that letter which would suggest that the intent of account holders was about to be overridden by new custodial policies.
When the Vanguard rep told me that it’s not an issue today, she meant that new IRAs don’t have this issue because the computer programming after July 2007 prevented clients from electing this option. Vanguard wouldn’t state how many existing clients have this issue, but at the time of the July 2007 mailing, there were 170,000 clients with multiple accounts of the same type that contained different beneficiary options. So the damage is going to be limited to people that created multiple accounts before July 2007 that did not act upon receiving the July 2007 mailing.
This issue has been litigated in the courts, and Vanguard has won. Their custodial agreement permits them to amend the agreement if they give notice and permit thirty days for objection, so the remaining clients affected by this arrangement have not found solace from the courts. I’d link to some of the cases this discuss this, but even though court cases are public record, I still feel uncomfortable highlighting family squabbles that directly involved people still living who are otherwise entirely private citizens. If this does potentially affect you, a few minutes on Google Scholar should give you the necessary guide posts.
Vanguard is in a great position of public trust within the investor community. People rely on them to always get it right. You can go to Schwab, American Funds, Citibank, Bank of America, or even E-Trade to create multiple accounts with different beneficiaries. This is a standard service. T. Rowe Price is the only other whale in the industry that does not permit it, but T. Rowe Price has an absolute ban in place that has always been the prevailing policy. Vanguard is the only one that has unilaterally made changes to investor intent created in the beneficiary forms.
It doesn’t get much attention because the multiple IRAs with different beneficiaries seems kind of weird to people, and the absolute number of people is small. My guess is there may be only 50,000 or so people out there still affected by this. The problem is the high-impact nature of the harm. And plus, being part of a small group that is greatly affected by something can be far more dangerous because the issue isn’t seen as big enough to warrant media attention that could give you appropriate notice beyond a July 2007 letter. I can’t imagine the pain of thinking you are getting millions of dollars in inheritance after a loved one expressed an entire to give it to you, and then you find out that someone else is legally entitled to that life-changing money because of Vanguard policy. A procedural tweak will let them play God with the lives of 0.0001% of Americans. A custodian should carry out, not make, inheritance wishes and my heart goes out to those Vanguard heirs affected by this.
Source Document: Vanguard Custodial Agreement