During the past few decades, U.S. households have begun to display increasing financial sophistication and awareness of rates of return on alternative investments. At the same time, the implicit rate of return on contributions to the social security system has declined as the system has matured, and this rate of return is projected to decline further in the twenty-first century in response to unfavorable demographic trends. This chapter examines the demand for financial assets by working investors by solving a calibrated life cycle model of consumption and portfolio choice with labor income uncertainty. Households are assumed to be constrained by restrictions on borrowing and short-selling risky assets. Heterogeneity across demographic groups appears to have important effects on optimal portfolios, suggesting the inadequacy of a “one-size-fits-all” social security system. In a benchmark case, the chapter shows a welfare gain equivalent to 3.7 percent of consumption from the investment of half of retirement wealth into equities, accompanied by a reduction in the social security tax rate to maintain the same average replacement rate of income in retirement.
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