A Performance Test for Your Self-Managed IRA or 401(k)

Note: This article is part of Morningstar's November 2013 Investor Starter Kit  special report. This article originally appeared Sept. 17.

Question: I manage my own IRA as well as my wife's, but I'm never really sure how good of a job I'm doing. Aside from comparing the portfolios' performance against the market, is there another benchmark I can use?

Answer: Managing your own retirement portfolio--whether it be invested in an IRA, 401(k), or similar account type--requires a certain degree of self-confidence. Financial advisors, of course, have made a livelihood from helping investors who want to outsource this job, and the growing popularity of target-date funds, which automatically shift the portfolio's allocation away from stocks and toward fixed-income as the account owner ages, give hands-off investors another option.

But even though the monthly or quarterly statements you receive from your IRA or 401(k) provider will tell you how your retirement portfolio is performing, they probably don't give you a suitable benchmark against which to compare this performance. Some investors might be inclined to compare performance against a commonly used equity benchmark such as the S&P 500 index, but unless your retirement portfolio holds nothing but equities--unlikely for all but the youngest retirement savers--that's not really an apples-to-apples comparison. (And even then, the S&P might not be the best benchmark for portfolios with a tilt toward smaller-cap or foreign equities.) The fact is that the most commonly used investing benchmarks measure the performance of large swaths of the stock or bond markets, but not both. For retirement savers with a diversified portfolio that includes a mix of asset types, let alone one that adjusts its allocation over time, these commonly used benchmarks are woefully inadequate.

Why a Target-Date Benchmark Makes Sense
For those aforementioned reasons, a target-date fund itself might be a better benchmark for your retirement portfolio. Morningstar.com readers may already be familiar with the idea of using target-date funds to help determine age-appropriate allocations to IRA or 401(k) accounts--something Morningstar's Christine Benz discusses in this article--but target-date funds also can serve as performance benchmarks.

The first step is to determine how your IRA and/or 401(k) has performed over time. You might find this on your account statement or by logging in to the account administrator's website. If you have multiple accounts that don't all appear in one place, you might want to input all your retirement holdings into a single portfolio using one of Morningstar.com's Portfolio tools. That way you can track all of your retirement savings holistically, viewing performance across various time frames as well as using the X-ray function to see how your overall asset allocation looks and how it compares with that of a target-date fund for someone your age.

Bear in mind, however, that the tools are only as good as the information you put into them. If you've been carefully tracking any changes to your portfolio over time, then your trailing-return numbers should be reliable. But if you were to input your holdings today and looked at trailing 10-year returns, for example, the results would be based on the assumption that you held your current allocation steady during the past decade. This may produce a less accurate measure of your portfolio's performance, as compared with a target-date fund, which has an allocation that adjusts over time.

Picking the Right Benchmark
The next logical question is which target-date fund or funds to use as a benchmark. Start just as you would if selecting a target-date fund for your IRA or 401(k) by choosing one closest to the year you plan to stop working. If retirement is 20 years away, then a fund with a 2035 target date would be the most appropriate benchmark. If you expect to retire in the next year or two, a 2015 target-date fund would be a better fit.

Next comes the question of which company's target-date fund to use as a benchmark, or whether to use a broader measure. If you prefer the latter, you could use Morningstar's Target-Date Indexes, which are used to benchmark target-date funds based on their equity allocations and which are found at the bottom of this page. Or you could use the target-date fund category averages listed under the Allocation Funds section here. In either case, be sure to choose the index or category average that most closely corresponds with the year you expect to retire and your allocation (if using the indexes). 

If you'd prefer to benchmark your IRA or 401(k) performance against a specific fund company's target-date series, just click on the link that corresponds with the year you expect to retire, and you'll find a list of funds, or find the fund using the Quote box at the top of the page. For starters, you might consider using an age-appropriate target-date fund from either Vanguard or  T. Rowe Price Group (TROW) because they offer the only target-date series awarded a Gold Morningstar Analyst Rating, meaning Morningstar analysts have the series for the quality of their management, performance, costs, and other factors. (If your retirement plan or IRA offers a target-date fund as an option, you could use that as a benchmark, too, though you might want to see what Morningstar analysts have to say about it first.)

Vanguard's target-date series is built around index funds, which might make it a better fit for investors looking for an index-based target-date benchmark. But T. Rowe Price's target-date series, based on actively managed funds, could serve as a benchmark for those wanting to see how the funds they've chosen perform relative to a portfolio of actively managed funds from a quality shop. Also keep in mind that different target-date series have differences in how much they allocate to stocks at any given time in their glide paths, which measure the stock/bond split of a target-date fund over time. For example, T. Rowe Price's glide path is tilted slightly more toward equities than Vanguard's. This can also affect the performance of a target-date fund versus your own mix of investments. Also keep in mind that, unlike an index benchmark, target-date funds charge fees, with higher fees resulting in lower returns. On average, investors in Vanguard's target-date series pay 15 basis points in expenses while those in T. Rowe Price's pay 79 basis points. 

If using one of Morningstar.com's portfolio tools to track your retirement account, consider adding a separate portfolio that consists of one (or more) of the target-date funds you've chosen as your benchmark(s). That way when you check how your retirement portfolio has performed, you can quickly compare it with the benchmark's performance from within the tool.

How Does Your Performance Compare?
Some investors may discover that managing their own retirement portfolios has led to results that consistently lag the target-date fund benchmarks and opt to make changes, including buying the benchmark funds themselves. Others may find they've outperformed, perhaps because of a heavier allocation to equities than the benchmark, or that they've underperformed because of an underallocation. Either way, using a target-date fund to gauge your success in managing your retirement portfolio is a fast and easy way to get a good idea of how you're doing relative to the pros. And best of all, it's absolutely free.

Have a personal finance question you'd like answered? Send it to TheShortAnswer@morningstar.com.