Japan Inc. must avoid America's astronomical executive pay

Wider CEO-employee compensation gap would threaten corporate harmony

Executive compensation at big, listed Japanese companies is steadily rising, with a large variable portion tied to shareholder returns. Yet average wage growth for workers is barely keeping pace with inflation.

Japan Inc. was once praised for its strong sense of community with management often regarded by employees as an extension of themselves. But is it now on a slippery slope to becoming as divided as corporate America by embracing shareholder-oriented capitalism?

Based on the data from the securities report publicly disclosed by Japanese companies in 2023, the average pay ratio between CEOs and employees at major Japanese corporations, with revenues exceeding one trillion yen ($6.5 billion) or more, was in the realm of a dozen to one -- a fraction of that at American firms in the S&P 500, where ratios of 200:1 to 300:1 are common, as revealed by AFL-CIO.

It took large U.S. companies just a few decades to balloon their CEO-to-worker pay ratio from a modest 20:1 in the 1970s to the astronomical figures of today.

Considering the accelerated pace of change, Japan Inc. must urgently consider the direct and indirect implications of this widening gap when deciding the long-term trajectory of executive and staff compensation. Semi-automatic benchmarking to global peers will only grow the pay ratio exponentially.

Such awareness will prompt large Japanese organizations to reexamine their narrative for attracting and retaining quality talent. If Japan-based multinationals can articulate such an alternate narrative while maintaining global competitiveness, they will have successfully set a direction toward compassionate capitalism as an antithesis to overtly shareholder-driven capitalism -- the harm of which to both the environment and humanity is becoming increasingly evident.

Beginning in March 2010, Japanese listed companies have been obligated to disclose executive compensations exceeding 100 million yen. The most substantial salary disclosed under this regulation was?10.3 billion yen?in March 2017. Since 2015, an increasing number of Japan's leading firms have been adopting performance-based compensation for their executives.

The genesis of this trend can be traced back to?the?Corporate Governance Code launched in 2015?under the second Abe administration, which encouraged tying executive compensation to long-term increases in enterprise value.

By stipulating the presence of more external directors on boards and unwinding cross-shareholding, Japan's corporate governance reform has enhanced the transparency and accountability of management, much to investors' delight. The higher risk, higher return nature of top jobs is another outcome of this reform.

But simply extrapolating the risk and reward correlation for management, with reward being financial compensation, is a flawed approach.

First, on an individual level, it is well established that real-life satisfaction gained from higher compensation saturates at a modest level: a study published on PNAS in 2023 shows the range around $60,000 to $90,000. While the appropriate range is culture-dependent, beyond a certain range the number on a pay slip simply serves the individual's vanity. While this can be a strong motivator to excel, it can also invite reckless behavior, especially if an executive is already financially well-off and only looks to make more money.

A larger problem looms at the organizational level. By decoupling the equation of executive pay from workers' wages, CEO-to-worker pay ratios will further expand -- and suddenly only the chosen few shoot up to levels of compensation unfathomable to most organization members.

Now that directors' compensation is a mandatory disclosure item, employees will roll their eyes at astronomical figures. Japanese companies have historically been accustomed to a democratic, if rigidly hierarchical, approach of nurturing top cadres seamlessly from staff to middle management to directors with corresponding incremental pay increases. Any major increase in executive pay risks this continuity and, with it, the sense of camaraderie.

Lastly, society at large will lose out by overlooking growing inequality. Frustration among the masses destabilizes society through political actions, as witnessed by the rise of populist leaders in developed nations. The economy will suffer too. Should employees, who also represent the lion's share of consumers, get an ever-shrinking shorter end of the stick, mass consumption will slow and ultimately this will hurt corporate earnings.

While these negatives for outsized executive pay are clear, Japanese companies may argue that their hands are tied on the world stage. To attract and retain top executive talent from the global pool, they need to match the compensation levels offered by Western or Chinese peers in their sector.

While I sympathize with this argument, I would argue that fixing the income gap for middle management and staff between Japanese companies and global peers is more urgent and likely more fruitful than poaching celebrity talent at the very top who may again leave for a better offer.

Slow wage growth against the backdrop of a stagnant domestic economy over the years has resulted in middle managers in Japanese companies being compensated on average at half of both American and Chinese peers. The gap, which starts at the bottom, only widens in the higher ranks.

Attracting promising talent into the bottom and middle of the organization will pay off over the long run. People will eventually grow into top management with in-house knowledge and networks if organizations can reward young talent with competitive pay and additional qualitative merits. Japanese companies can promise job stability -- a scarce commodity in the modern working world -- and global career upward mobility. The us-before-me mentality of Japanese teamwork may not work for everyone but is not without some level of universal appeal.

With income disparity relatively under control compared to its Western peers, Japan Inc. may not find itself at immediate risk of becoming as divided as the U.S. But a blind copy-and-paste approach to executive pay scales is concerning. Tasked with designing executive compensation while holding management accountable for the long-term viability of the organization, boards must holistically weigh wage trajectories: not only for the select few at the top but for all ranks.

The father of modern marketing, Philip Kotler said on Medium in 2023, "There is evidence that some pay packages [of those executives] pay little or no attention to social issues and other pay packages may overdo it and end up hurting current performance."

And as more executives realize that "enough can be enough" and resist the urge to accumulate personal wealth with no end, we will take a collective step forward toward a more sustainable society.

This article was published by Nikkei Asia on August 8th, 2024.