Running out of money in retirement and existing on the age pension alone is not most people's idea of a comfortable retirement. But longevity risk - the risk of outliving your savings - is looming as a greater risk than investment risk.

Markets recover eventually but the period of time that needs to be funded in retirement is ever-growing.

The Australian Bureau of Statistics says the number of people aged 85 years or older is projected to grow from 334,000 in 2007 to 1.7 million in 2056.

A principal at superannuation consultant Watson Wyatt, Nick Callil, says there is a 50 per cent chance that half of today's 65-year-old self-funded retirees will live to 90.

Anyone lucky enough to have a defined benefit pension would have been left unscathed by the global financial crisis but those with account-based pensions would have taken a sizeable hit. They will probably be worrying they are too exposed to risky assets and are likely to run out of money.

The managing director of SuperRatings, Jeff Bresnahan, says most retirees have their money in their super funds' balanced investment options, which have between 60 per cent and 76 per cent of their money in growth assets such as shares and property. That's a large exposure to risky assets by developed-world standards. About 20 per cent of retirees' money is in conservative and capital stable investment options, with 15 per cent in cash, up from less than 4 per cent before the global financial crisis (see bar chart, page 6).

However, any knee-jerk reaction to

re-weight retirement savings too heavily to secure investments would be potentially counter-productive, says the co-founder of the researcher Chant West, Warren Chant. Having a retirement portfolio set too conservatively means significantly lower retirement income. Chant points out that most people pick up at least a part age pension adjusted for inflation, which means most retirees can invest their savings more aggressively.

About 60 per cent of retirement income comes from earnings after retirement, says the head of structured solutions at AXA, Andrew Bartlett.

"While bonds offer certainty of income in retirement, they also forgo the growth, which can be a very large part of your wealth strategy," he says.

Saving as much as possible through salary sacrificing is the best insurance against longevity risk, says a financial planner and director of WLM Financial Services, Laura Menschik. In the accumulation stage, savers would want reasonable exposure to growth assets. But growth assets are still needed in retirement. "At age 65, if you are going to live another 20 or 30 years, that's a long time and retirees need to take advantage of some growth assets."

Menschik says retirees should always have one or two years' worth of income in cash. "They could have $25,000 or so ... so that through the difficult times they have the cash to pay their income without having to sell their growth assets when markets are going down."

'Trilemma'

Financial services institutions are responding to retirees' concerns over longevity risk with investment products that emphasise income in retirement.

Challenger is the biggest provider of annuities and some life insurers have introduced allocated pensions that come with income or capital protection.

However, they are expensive and can be complex, especially for older retirees.

"People face what I call a trilemma," says a partner in Mercer's retirement, risk and finance business, David Knox. "They want good investment returns, they want access to their money and they want security. But you cannot have it all in one product."

Knox says there are three phases to retirement. The first is the active phase where the expenditure is high; then there is the passive phase; and finally there is what Knox calls the "frail" phase. "Each of those phases is quite different and to have a single product that meets all of the needs in retirement over such a potentially long time-frame is very difficult, if not impossible," he says.

The simplest approach in helping to mitigate longevity risk is to increase exposure to fixed interest. It will not eliminate the risk, as only products that guarantee to pay income for life can do that, but it will go a long way to reducing the risk of running out of savings.

Managed funds that invest in fixed-interest securities of high credit worthiness and have sizeable exposures to government bonds will produce stable capital and recurring income, pretty much regardless of market gyrations.

Fixed interest can be accessed through an allocated pension that, in turn, invests in managed funds or balanced funds with big exposures to fixed interest. All the big superannuation funds have pensions that have a suite of investment options, including cash and diversified portfolios, with different risk versus reward trade-offs.

A financial planner and principal of Paramount Wealth Management, Wayne Leggett, says the amount of risk people can manage varies and it is usually not that dependent on age.

He says a more adventurous 65-year-old can be more comfortable with risk than a conservative 40-year-old. Leggett prefers his retiree clients to take as much risk as they can handle so their capital will last as long as possible.

Options

SuperRatings' Bresnahan says there is no single, correct answer to asset diversification in retirement.

"The whole point is that people need to understand where they are invested and what risks that carries so that they can make appropriate decisions."

SuperRatings has been running a campaign to put pressure on super funds to clearly state what are the expected returns above inflation and the expected frequency of years of negative returns for each investment option.

Bresnahan says if all funds did that, their members and their financial advisers would be in a much better position to make well-informed decisions.

He says investing should be kept as simple and as transparent as possible and if retirees do not understand how an investment works, then "don't touch it".

The "original" asset classes do a perfectly good job, Bresnahan says, and they should be able to be used in a portfolio to suit each investor's appetite for risk.

But getting people interested in their super is proving an uphill battle.

Retirees did switch about 10 per cent of their assets to their funds' cash investment options during the global financial crisis. About 15 per cent of retirees' allocated pension money is in cash.

Leaving cash on the sidelines to cover income when markets turn down is a sensible move but 15 per cent is a big chunk of savings upon which there will be no capital growth. Apart from shifting some of their money to cash, most remained in their funds' default options. Bresnahan says the data shows most people stay in their funds' default options, probably through apathy.

Another possible pitfall for retirees, and anyone still saving for their retirement, is that a fund's investment options may change how they invest over time and expose members to more risks.

Many funds' conservative options, for example, are not as defensive as they used to be as competition among funds has seen them increase their exposures to lower-quality corporate debt, emerging market debt and mortgage-backed securities. They have been allocating less of their member's money to the traditional defensive investments such as investment-grade corporate bonds, government bonds and cash.

Even cash options were not immune from creeping up the risk ladder. The "cash" options of some of the largest funds produced negative returns during the GFC. The funds have changed their cash options back to pure cash or added pure cash options to their line-up of options.

The case for annuities

The traditional approach to managing longevity risk is a class of life insurance products called lifetime annuities. These have not been popular with retirees because traditional annuities may leave no capital for the estate and pay low interest rates.

For a price, they can be made more flexible, such as by having some capital reversion to a spouse on the policy-holder's death and the income inflation-adjusted. Only one major insurer, the Commonwealth Bank's CommInsure, offers lifetime annuities. But others offer term annuities for fixed periods.

Challenger, the largest provider of annuities, wants the Government to force retirees to put 30 per cent of their nest egg into annuities on retirement. It says that by forcing everyone — both the good and bad risks — to take an annuity, it could offer higher yields. However, critics argue it would be unfair to force those who may not have a particularly high life expectancy to put at least part of their retirement nest egg into an annuity.

The head of longevity solutions at Macquarie Bank, Andrew Robertson, says annuities could be made more attractive so retirees would buy them voluntarily. He says a market-linked allocated pension could be modified so retirees in effect pay an insurance premium and, if their market-linked portfolio runs out of money, they receive guaranteed income payments for the rest of their life.

AXA has an allocated pension called AXA North that offers capital protection, while ING's MoneyforLife is the first allocated pension to come with a guaranteed income for life.

The managing director of research firm DEXX&R, Mark Kachor, says more of this style of products will come on to the market. While the products are fulfilling a need, he says they will not suit all retirees because the guarantee, whether income or capital, has to be paid for through higher fees. The ING product, for example, has fees of at least 3 per cent, depending on the underlying investments.

Another potential concern is that these products are contracts between the institution and the investors that could last for 30 or more years. AMP has made a proposal to take over AXA's Australia and New Zealand business and ANZ has recently bought the half of ING Australia it did not already own.

The chief economist at AMP Capital Investors, Shane Oliver, says that in later retirement, most people do not want to have to worry about investment markets and want to scale down to cash and the age pension.

He says these structured products sound appealing but retirees may be giving up a lot by way of returns. He says retirees can create simpler solutions and a good financial planner should be able to come up with the right mix of assets that give them "95 per cent" cover for longevity risk.

The DIY alternative

Those with self-managed super funds could invest directly in long-dated, inflation-linked government bonds. For example, $100,000 put into a bond paying 4 per cent would pay an income of $4000 in the first year. If the bond is inflation adjusted, the $4000 will increase each year with inflation. The $100,000 also grows with inflation and, at the end of the term, the inflation-adjusted capital is returned to the investor, says Justin McCarthy, the head of research at FIIG Securities. They are very simple investments, backed by governments.

The very long-dated bonds of the big four banks generally offer the best yields but the minimum investment is $500,000. The minimum for government bonds varies from $1000 to $20,000. The bonds can be sold before the term is up. But if interest rates have increased since the bond was bought, the capital value of the bond will be lower.

While people may be tempted to put money in a term deposit or cash management account, that is appropriate for, at best, up to two years. The returns are too low to justify longer than that, says a fixed-interest dealer at Cameron Stockbroking, Tony Lewis.

"We can set up an annuity-style investment portfolio going out 20 to 30 years with a mixture of government securities and high-quality securities," he says.

The trick is to diversify and have rolling maturity dates. A handy place to keep money at call is in online savings accounts, such as ING Savings Maximiser, which pays 4 per cent, and St George Direct Saver, which pays 3.7 per cent.

Those with self-managed super funds can also invest in direct shares and bypass the fund managers and their fees.