Like every other aspect of physician life, almost perfect is good enough
Some of us strive for the optimal solution in retirement planning. But what if you cannot achieve that optimal solution and instead settle for reality?
Let’s look at the theory of second best and understand why reality is good enough.
What Is the Theory of the Second Best?
Economists Richard Lipsey and Kelvin Lancaster formalized this theory in 1956. It states:
If a system cannot be perfect in all aspects, attempting to optimize other parts of the system may degrade the overall outcome.
An analogy is when you are cooking but missing a key ingredient. The best approach isn’t to make everything else exactly according to the recipe but rather to adjust other ingredients to create a different dish. If the dish cannot be perfect because of a missing part, don’t optimize the other ingredients; create a new dish.
When one of the optimality conditions cannot be met, the solution requires adjusting other variables in a way that might seem counterintuitive. It produces the best possible outcome given the constraints.
The Theory of the Second Best addresses situations where one or more conditions for achieving an optimal economic outcome cannot be satisfied. In such cases, the theory suggests that the next-best solution might deviate from other optimality conditions, potentially leading to a better overall result than trying to fix just one issue.
Application to Young Physicians’ Finances
This theory can be particularly relevant for young physicians, who often face unique financial challenges such as high student loan debt and complex tax situations. It implies that when the “first best” financial strategy—such as maximizing retirement savings while minimizing taxes and eliminating debt quickly—isn’t feasible, a “second best” approach might involve prioritizing certain goals over others. For example, focusing on debt repayment first, even temporarily contributing less to retirement, could be more effective given cash flow constraints.
Why This Matters in Physician Financial Planning
Physicians and high-income professionals encounter “second best” scenarios constantly. Consider these examples:
A young physician with $300,000 in student loan debt at a 6% interest rate. The “first best” strategy might be to pay off the debt aggressively while maxing out retirement accounts. This might not be feasible if monthly cash flow is tight (high living expenses or practice startup costs). A “second best” approach could involve prioritizing debt repayment first, even if it means contributing less to retirement for a few years, or vice versa, depending on the interest rate and tax benefits of retirement contributions.
In tax planning, the “first best” might be to minimize taxes, potentially through strategies like Roth conversions or tax-loss harvesting. However, it takes time to learn how to do this (and follow through) or you could pay an advisor to do it. A “second best” strategy might involve VTSAX and forget it, even if it means paying slightly more in taxes.
Practical Implications and Strategies
Applying the Theory of the Second Best to physicians’ financial planning involves several practical steps:
- Identify Constraints: assess the most pressing financial challenges, such as debt, tax problems, or insufficient emergency funds.
- Balance Multiple Goals: achieving all financial objectives simultaneously is impossible.
- Remain Flexible: financial situations evolve, and what was a “second best” strategy last year might not be optimal this year.
The Theory of the Second Best offers a valuable framework for physicians navigating the complexities of personal finance. It underscores that striving for perfection in one area might not always lead to the best overall outcome in an imperfect world. By accepting some imperfections and finding a balance, physicians can make informed decisions that align with unique constraints and goals.
Finding Your Second Best in Retirement
In retirement, we often face constraints that prevent us from achieving theoretical perfection.
Remember that “enough is the goal in retirement rather than abundance”. Finding your personal “second best” might actually create more satisfaction than endlessly pursuing the unattainable perfect optimum.
It acknowledges that perfection is rarely attainable and that intelligent adaptation is more valuable than rigid adherence to idealized plans.
Physicians can apply this theory by identifying their most pressing financial constraints, balancing multiple goals, and remaining flexible as circumstances change. This approach helps find the best possible balance given the unique situation.
The theory of second best reminds us that flexibility and adaptability often trump perfect execution of an outdated plan.
If one condition for optimality cannot be met, the next-best solution might involve adjusting other variables away from their optimal values.
While the theory originated in macroeconomics, its principles can be extended to personal finance, especially for high-income professionals like physicians.
The “first best” in personal finance might be maximizing retirement savings, minimizing taxes, and quickly eliminating debt. However, constraints like limited cash flow or high interest rates on loans might make this ideal unattainable. The Theory of the Second Best suggests that instead of striving for perfection in one area, physicians might need to find a “second best” strategy that balances multiple goals, accepting some imperfections to achieve a better overall outcome.
Like every other aspect of physician life, almost perfect is good enough.