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Investing Specialists

A Roadmap for Assessing Retirement Portfolio Performance

Comparing your portfolio with a good target-date fund or a customized benchmark can help you determine how you're doing.

Note: This article is part of Morningstar's January 2015 5-Point Retirement Portfolio Checkup special report.

Anyone who's ever gotten lost while traveling in an unfamiliar city or foreign country knows how disconcerting it can be (thank goodness for GPS!). The same thing goes for retirement saving. While you probably have some idea where you want to end up in terms of a retirement lifestyle, you may not have a good idea of whether you're on track to get there.

Perhaps you've already taken the first steps, determining how much you already have saved up and whether your saving rate is sufficient. Next come decisions about how you want your retirement portfolio to look--in other words, its asset allocation and investment selection. But once these tasks are done, your job still isn't finished. You'll need to monitor your portfolio's performance over time to make sure you stay on track. But what's the best way to do this?  

Of course, you could always take the lazy way out--opening up your 401(k) and IRA statements each quarter, glancing at the total value of your holdings and comparing it with the quarter before. If the number is higher, you figure things are peachy, and if they're lower, you figure they're not. But all that's going to tell you is whether your portfolio's headed in the right direction. And if you are still contributing to the account, that growth in asset size may be more attributable to new money you've added than to good investment performance. 

Your 401(k) or IRA statements also may include information on how the account or its individual holdings performed over a given period relative to a benchmark, such as the S&P 500 Index of U.S. large- and mid-sized company stocks. But if you have a well-diversified portfolio that includes ample helpings of bonds and foreign stocks, comparing its performance with that of the S&P 500 is a bit like comparing apples to oranges (or at least like comparing apples to a fruit salad in which apples are just one ingredient).

Tracking Target-Date Performance
A better benchmarking option is to use a target-date fund designed for investors with the same retirement time frame as you. Why? Because while the most widely used benchmarks focus on a particular group of stocks or bonds, target-date funds typically hold broadly diversified portfolios with stock/bond allocations considered suitable to the risk tolerances of investors of a given age. In fact, a quality target-date fund can serve a dual benchmarking purpose for investors, providing them with a yardstick against which to measure not only their retirement portfolio's performance but their asset-allocation decisions as well. For example, if your retirement portfolio has a much higher or lower allocation to equities than an age-appropriate target-date fund uses and consistently lags, that may be a signal to you to revisit your allocation and/or investment selection.

Many 401(k) plans include target-date funds in their fund lineups--and even if yours doesn't, you can always find performance information for target-date funds from various providers on Morningstar.com. The Vanguard Target Retirement series funds are particularly well suited for this purpose because they are built using low-cost index funds that track commonly used benchmarks for various asset classes.

However, even a good target-date fund might not be the best benchmark for your retirement portfolio. That's because target-date funds typically stick to the asset allocation the fund company thinks is best for investors of a certain age. This allocation is often backed by fund-company research but still can vary from target-date series to target-date series, meaning some may work better as a benchmark for you than others. Also, it's possible that no target-date fund's allocation will seem particularly relevant to you if your risk tolerance is unusually high or low. For example, you may think they all allocate too little to stocks, or too much.

Additionally, be aware that fund fees can eat away at performance. If you are benchmarking a portfolio made up primarily of individual stocks and/or low-cost index funds against a target-date benchmark that charges unusually high fees, you may come away with the impression that you are a world-class stock or fund picker when, in reality, a good chunk of your portfolio's outperformance is due to its built-in cost advantages over the pricey target-date benchmark. That's another reason why a low-cost, index-based target-date fund often makes for a better benchmark than a more expensive target-date fund.

Building Your Own Custom Benchmark
If no target-date fund seems like a good benchmark for your retirement portfolio, perhaps because your allocation simply does not match up well with any of them, you might want to consider building and tracking your own custom benchmark. And even if your allocation is in line with a target-date benchmark, you still may want to use a custom benchmark to compare the performance of your individual holdings with, so as to identify those that are underperforming.

As Morningstar's Christine Benz describes in this article, you can build your own benchmark portfolio using a mix of low-cost ETFs (or index-based mutual funds) that mimic the same asset allocation used in your retirement portfolio. For example, if your portfolio consists of 60% U.S. large-cap stocks, 20% U.S. small-cap stocks, 10% foreign stocks, and 10% U.S. investment-grade bonds, you could set up a portfolio with a 60% exposure to an ETF that tracks the S&P 500, a 20% exposure to an ETF tracking the Russell 2000, a 10% exposure to an ETF tracking the MSCI EAFE Index, and a 10% exposure to an ETF tracking the Barclays U.S. Aggregate Bond Index.

Once you've chosen the pieces you want to use for your custom benchmark, you can use the Portfolio Manager tool to track the performance of your retirement portfolio against that of your custom benchmark. Just enter each portfolio separately, and then use the drop-down menu at the upper left to toggle between the two. (To keep your portfolio up to date, you'll need to enter any additional contributions or trades you make on an ongoing basis and update your benchmark accordingly. Be aware that some of this functionality isn't available for Watch Lists, so both your portfolio and its custom benchmark must be entered into the Portfolio Manager tool as portfolios. Also, Premium Members can use the X-Ray feature in Portfolio Manager to keep the allocation of their retirement portfolio and that of their custom benchmark in sync, while others may want to use the Instant X-Ray tool.)

Another useful tool within the Portfolio Manager is the "My Performance" tab , which allows the user to compare the portfolio's overall performance, as well as that of individual holdings, against a given benchmark. You can look at up to a decade's worth of past performance or focus in on how the portfolio has performed over just the past 12 months. (If the portfolio has been in existence for less than 10 years, you will only see performance data for the relevant time period, and even if it wasn't saved to Morningstar.com for that complete time period, you can still enter it retroactively.) Bear in mind that a portfolio that underperforms its benchmark in the short term isn't necessarily a lost cause. But prolonged underperformance may be a red flag and a sign that changes are warranted.

The tool also tells you your personal rate of return and the total return for individual holdings and for the entire portfolio. Personal rate of return represents the actual performance experienced by the investor over a given time period while total return represents the performance experienced by investors who owned the fund over that entire time period without adding or subtracting assets. These two figures can differ if the investor bought or sold shares or did not own specific holdings for the entire time period.

Once you've arrived at an effective benchmark for your retirement portfolio and tracked the portfolio's performance against it for a while, you should have a better handle on how you're doing. Perhaps you'll see no need to change a thing, or maybe there will be areas that aren't performing as well as you'd like and where change is needed. Or perhaps you'll discover that an index-based approach and/or using a target-date fund would serve you better in the long run. Whatever the result, finding out how your portfolio has been performing is key to staying on the right path to the retirement you want.

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