As investor eyes are upon Japan, corporate governance is front and center. The past few years have seen attention shifting from board independence to gender diversity, skills-based boards, and capital allocation. Now in greater focus is the role of the compensation committee and the necessity to redefine executive compensation in Japan. The compensation committee has a crucial role in determining pay structures, setting performance metrics, and evaluating executive performance.
Why Compensation Matters
CEO pay in Japan has traditionally been quite low, with a culture focused more on harmony and contribution, and an emphasis on preserving the corporate entity and jobs, which discouraged risk-taking and growth. While this may seem noble in contrast to the US-style Adam Smith capitalism philosophies which have allowed for unimaginably high pay packages and staggering CEO to average pay ratios. The lack of long-term incentive compensation has also had and may continue to have an impact on the competitive advantage of Japanese firms. First, compensation is not appropriately encouraging risk-taking. Second, lower compensation may result in a loss in the war for talent that is necessary to drive future growth.
Jun Frank, Managing Director and Global Head of Compensation and Governance Advisory at ISS-Corporate shares that:
“Effective corporate governance requires both monitoring by an independent board as well as appropriate incentives to help induce management to act in shareholders' best interests. You really need both monitoring and incentive to have an effective corporate governance mechanism.”
In addition, Jun shares through reviewing pay compensation structures, investors can understand how the board is measuring success and also how the board is holding management accountable for failure. Compensation offers a glimpse into how well the board is functioning.
The Current State of Compensation Committees in Japan
In Japan, the evolution of compensation committees has been marked by a growing recognition of their importance in corporate governance. As background, compensation committees are relatively new in Japan. Japan has three board structures, and the majority of companies use the traditional “Board with Corporate Auditors” structure (監査役設置会社). Formal compensation committees are only legally required for companies who chose the US-style three-committee structure (指名委員会設置会社). Because compensation committees are relatively new, there are few directors with experience on compensation committees as well as limited knowledge of best practices. In recent years, the majority of listed companies have established “voluntary” compensation committees.
Japan’s Corporate Governance Code, established in 2015 under former Prime Minister Abe’s Third Arrow for economic reform, addresses compensation in Principle 4.2, the Roles and Responsibilities of the Board:
“The board should view the establishment of an environment that supports appropriate risk-taking by the senior management as a major aspect of its roles and responsibilities... Also, the remuneration of the management should include incentives such that it reflects mid- to long-term business results and potential risks, as well as promotes healthy entrepreneurship.”
While most compensation committees are comprised of a majority of independent directors, insiders still exert significant influence. Compensation committees may simply endorse the recommendations of management. As the role of the compensation committee in Japan is gradually becoming more defined, there is an opportunity to define compensation structures that align with Japanese culture, investor expectations, and the realities of a competitive marketplace.
Compensation Structures: A Comparative Analysis
ISS-Corporate analysis based on data as of mid-July 2024 estimates that median pay for CEOs was $14.4 million for S&P 500 companies, $4.8 million for Russell 3000 companies (ex-S&P 500), and $2.9 million for Stoxx Europe 600 companies.* In comparison, a Deloitte Tohmatsu survey found that the median compensation of Japanese companies with at least JPY 1 trillion of sales ($6.6 billion) was JPY 123 million ($820,000). Notably, while there are significant differences in pay, there is also a significant difference in the size of Japanese companies vs. US S&P companies. In addition, the majority of US pay (75%) is from long-term incentive (LTI) equity compensation. While select Japanese firms have added LTI equity incentive structures, this practice is still relatively new in Japan and far from common practice.
Conclusion
Compensation committees play a critical role in shaping corporate strategy and driving long-term success. Compensation committees face numerous challenges in Japan including balancing expectations of shareholders, global competition for talent, and cultural norms related to executive pay. However, at the core is the importance of committee composition, committee education, and a desire to elevate corporate governance.
This summary was based on the JBDN's event The Role of the Compensation Committee. Please contact us for a replay.
*ISS-Corporate, based on ExecComp Analytics database. Data as of mid-July 2024. Excludes benefits, perquisites, pension, and other compensation. Due to differences in reporting standards, pay information is adjusted to standardize the data. Data as of mid-July 2024. USD, exchange rate as of June 30, 2024.