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Feb 17, 2021

How performance-based pay can drive up executive compensation: A Japan case study

In a bid to improve corporate governance, Japan is inadvertently pushing up CEO pay

An increasing focus on performance-based pay and long-term incentives is driving up CEO salaries in Japan.

In fiscal year 2019 alone, CEOs saw total pay jump by a huge 20.5 percent, according to a study by Willis Towers Watson (WTW) published at the end of last year. This was, say the study authors, ‘driven by a significant expansion of long-term incentives’ in Japanese pay structures. It also represents a huge jump on the 3.3 percent rise the year before.

The report authors note that although Japanese CEOs are still compensated at significantly lower levels than US and Europe-based peers, the structure of compensation plans is changing quickly.

‘CEO pay mix has shifted significantly from a fixed-variable ratio of 58:42 in our fiscal year 2015 analysis to 40:60 in fiscal year 2019 analysis,’ Naoto Ogawa, senior consultant in executive compensation at WTW in Japan, tells IR Magazine.

A big shift here has been Japan Inc’s drive for better corporate governance. ‘Companies have been encouraged to put more focus on performance-based pay under Japan’s Corporate Governance Code,’ explains Ogawa. ‘Disclosure regulation has also been developed and companies are now required to disclose KPIs for incentive pay – as well as why they chose those KPIs.’

A major turn

WTW’s most recent research on the topic, which looks at CEO pay, is based on publicly available data for 429 companies in Japan, France, Germany, the UK and the US (and which is ‘minimally’ impacted by Covid-19 because the reporting period goes up to March 2020), points out that the structure of compensation plans in Japan ‘is starting to mirror those of European companies that place a heavy emphasis on performance-linked pay.’

The change is happening quickly, too. As well as a big increase in total CEO pay from fiscal year 2018 to 2019, WTW finds that compensation plans in 2019 were composed of 29 percent long-term incentives (LTIs) – an increase from 21 percent the year before.

In 2019, 40 percent of Japanese CEO compensation was fixed. The remaining 60 percent was almost equally split between LTIs and annual incentives (31 percent). For comparison, WTW says this split in the UK was 25 percent base salary, 46 percent LTIs and 29 percent annual incentives. In the US, just 10 percent of total CEO compensation is made up of base salary, with annual incentives accounting for 18 percent. A whopping 72 percent of total CEO pay in the US in fiscal year 2019 was made up of LTIs.

This shift toward using incentive-based pay, says WTW in its research, ‘may mark a major turn in Japanese compensation practices when compared with practices that were common in 2015 when the Japanese Corporate Governance Code was first introduced’.

But it’s not only the governance code, which came into effect in Japan in 2015, that is driving this trend. Ogawa says ‘investors’ active engagement [and] discussions among companies’ remuneration committees’ as well as the fact that ‘more non-executive directors now play a significant role in executives’ nomination and remuneration’ are all having an impact.

Ogawa adds that while WTW’s recent research was focused on CEO pay, other senior company executives ‘typically have the same incentive plan as the CEO’, albeit with the necessary adjustments such as for responsibility and department. The consultancy has been looking at CEO pay in Japan for around 20 years and Ogawa explains that for a long time there was little change – median pay even dipped during the financial crisis.

Today, though, ‘the gap between the 90th percentile value and the median value is widening,’ he says. What this means is that ‘some high-paying companies are no longer looking at classic Japanese companies but at European/US peers for compensation benchmarking purposes.’

Despite this big jump in Japanese CEO compensation in fiscal 2019, WTW stresses that ‘the trend of US and European companies paying their CEOs significantly higher amounts in total compensation than [those] in Japan remains unchanged.’

Still, WTW notes that the number of companies paying ‘especially high levels of compensation’ continues to climb: 18 of the companies surveyed in the most recent research paid their CEOs at least ¥300 mn ($2.75 mn at the time) in fiscal 2019, up from 15 companies in fiscal 2018. Thirteen firms paid their top executive more than ¥400 mn in fiscal 2019, up from 11 firms in fiscal 2018.

A wider lesson

It’s a good thing investors and other stakeholders are getting more comfortable asking questions about executive compensation: Ogawa says clients now more often say investors are taking time to ask questions around executive pay during their engagement activities, rather than just at the AGM.

But Pru Bennett, partner at Brunswick Group and a member of the Asian Corporate Governance Association, points to the trend as an example of where the push for an ever-greater portion of the salary at risk can have negatives as well as positives. In Japan but also more widely across Asia, she says the first thing to ask is: ‘Is excessive remuneration a problem? Probably not, but I don’t think enough research has been done around that.’

There have, of course, been cases where executive pay ‘doesn’t look too good,’ she tells IR Magazine, though ‘it was nothing like what you see in the US.’ But the risk of increasing the performance-based proportion of what is already a not-unreasonable salary is the possibility of a ‘ratcheting-up effect,’ she warns: exactly what WTW is seeing in Japan.

Culturally, Bennett says Japanese CEOs have never wanted to be rewarded with pay that is hundreds of times that of the average worker. But those CEOs ‘have a mortgage, they have kids in school and they simply can’t live with high levels of fluctuating pay,’ she says – all while investors are calling for ‘yet more to be put at risk.’

With many investors now calling for ESG metrics to be added into the mix of LTIs, perhaps there should also be wider discussion about how these trends can in fact drive up executive compensation – at a time when investors and the media regularly call out companies in Europe and the US for excessive pay. ‘Investors need to be careful what they wish for because there can be unintended consequences,’ warns Bennett.

Garnet Roach

An award-winning journalist, Garnet Roach joined IR Magazine in October 2012, working on both the editorial and research sides of the publication. Prior to entering the world of investor relations, her freelance career covered a broad range of...