The Myth of Seniority Wages

KOIKE Kazuo

A myth is a story that has been passed on from times of old but that is of dubious veracity, being based on hazy evidence. Many myths are current in Japan, particularly in the area of the labor practices of companies. In this essay I focus on the myth of seniority wages. While this is just one of numerous myths, to try to cover more in limited space would mean giving each only light treatment, thereby inviting misunderstanding. I shall, however, also make mention of the exaggerated notion of the role of the government, one of the myths in the broader sphere of the Japanese economy.

The myth of seniority wages can be summed up briefly as the idea that Japan’s pay system differs from others in that it links pay to years of continuous service, not to the abilities or achievements of the individual. If we were to ask people what they see as the key parts of the pay system, we would probably receive two answers. First, they would point out that wages are regularly increased, and while the size of the hikes varies somewhat from one employee to the next, all employees continue to enjoy rising wages until they reach retirement age, as long as they continue to work for the same company. Within the company there is a defined set of job grades that more or less determine the pay for a class of work, not for each individual job. The pay for all employees at each job grade is not, of course, identical. Each grade has a broad range, and the individual at that grade will receive regular pay increases in yearly increments within the range. There will also be a certain amount of duplication in the amounts of pay between neighboring job grades. The technical term for this duplication in pay scales is “overlapping range rates.”

Second, we would be informed that one of the best features of this pay system is that it alleviates competition among individual employees. Because pay is not based on the skills and performance of the individual, there are only small salary differences among all employees in the same job grade with about the same length of employment. Such personnel have no reason to compete with their peers, it is said.

A MISGUIDED REFORM DRIVE

One of the foundations of the myth of seniority wages is a misunderstanding of how pay is determined in Western companies. The misunderstanding has two parts: (1) Because many Western firms evaluate the abilities of their employees, it is assumed that pay is basically determined by the job and rises or falls according to the individual’s performance, without increases in yearly increments. (2) It is also assumed that under such a pay system there naturally must be huge differentials in pay depending on the individual.

Within the Japanese corporate world, there were even attempts to move closer to this misperception of how Western countries handle pay, and they resulted in inopportune reforms of pay systems that only made them worse. Starting around the end of the 1990s, perhaps as many as one-third of Japan’s major corporations introduced new systems that, especially in the case of management personnel, who are not members of labor unions, eliminated the yearly increments. Amounts of pay were instead linked to the job. For instance, a personnel section manager might have a set salary of ¥500,000 per month. Next, a sum known as merit pay would be tacked on to the salary. This sum did not build up year by year. Instead, it lasted only for a single year, and the next year a new amount would be decided on. In this way the section manager’s merit pay could be ¥150,000 per month in the first year but only ¥90,000 in the second. Such a manager’s total monthly pay would thus drop from ¥650,000 in one year to ¥590,000 in the next. In other words, this salary system allowed for reductions in “base pay,” which in Japan’s case should be defined as the total of all payments excluding bonuses. To be sure, the details of how these systems operated in practice are not known, so nothing definite can be said about how large the pay cuts suffered by some management personnel were. But at least in theory, the systems made deep cuts possible.

Revisions were also made to the range rate systems. In a nutshell, the ranges were narrowed. The breadth of a range is normally measured in percentage points by the difference in pay from the bottom of the range to the top. In the case of pay for the section manager class, for example, if monthly pay varies from ¥400,000 at the bottom to ¥600,000 at the top, the range has a 50% breadth. The reforms narrowed the ranges to figures like 20%, and they aimed to eliminate most of the overlap with range rates for neighboring job grades.

One further objective of the reforms needs to be noted: They sought to widen the differentials among employees. Even personnel within a single job grade would be awarded substantially different pay amounts.

AMERICAN AND JAPANESE SALARY SYSTEMS

How do companies in the United States actually handle pay? The following comments are based on reliable literature and reference materials, although I have not, for the most part, listed sources in order to save space. My concern is with the salaried workers known as “exempt employees,” generally administrative, executive, or professional employees who are exempt from certain legal provisions concerning wages and working hours. They correspond with Japan’s college-educated white-collar employees. This discussion does not cover secretaries and clerks. Pay for blue-collar work is also a separate matter. Generally that depends on the job and does not rise in yearly increments coupled with a merit rating.

Broadly broken down, the compensation for exempt employees has two parts: base pay and variable pay. Base pay is the fixed component of compensation, which we have been looking at. Variable pay is the amount added to base pay, and the function it serves in the United States is similar to the function of bonus payments in Japan. There are, of course, other American pay systems, such as those used in investment banks for staff members in charge of derivative financial products, but here I shall discuss only the general salary system.

Now let us look into the mistaken Japanese assumptions about this system, starting with the first point cited above, namely, that pay is determined separately for each job and rises or falls according to performance. The fact of the matter is that base pay in the United States is by no means a “pay for job” system. There is no single salary for a specified position, such as $50,000 per month for a personnel section manager. Instead, he or she will be compensated at a range rate, which might result in base pay somewhere between $40,000 and $60,000. The range rates will generally apply to all managers in the section manager class, such as the heads of the marketing or production control sections. We may call it, accordingly, a “pay for job grade” system, although other terms are also used. The pay will, moreover, rise in regular steps. While merit ratings are conducted, the section manager can expect the base pay to move up to $60,000, and in some firms there are arrangements for hiking salaries above the upper limit. Some Japanese firms have similar arrangements.

Given the reputation the United States has for being a meritocracy, many Japanese take it for granted that employees who put in a poor performance suffer cuts in their base pay and may even be demoted. This, though, is incorrect. A number of fine studies have been conducted on individual American corporations. By means of detailed analyses of employees’ personnel records, they confirm that American employees rarely suffer demotions or salary cuts. One of these is “Do Formal Salary Systems Really Matter?” by Michael Gibbs and Wallace Hendricks (Industrial and Labor Relations Review vol. 58, no. 1 [October 2004]). This study examined 50,000 records from a major corporation over a five-year period, and it found that only 0.4% of the records pertained to demotions and 0.2% to base pay reductions.

Thus far I have been talking only about base pay. When we extend the talk to variable pay, we naturally find that compensation can be reduced depending on the performance of the company, the division, or the individual. But this variable pay is, like Japan’s bonuses, an amount added to base pay, and these bonuses are also reduced in years of a poor performance by the company, division, or individual. In addition, Japan’s bonuses are a much larger component of compensation than is American variable pay. In the division manager class there may be no great difference, with this variable component amounting to about one-third of compensation in both countries. Below that, though, American variable pay dwindles to one-fourth of compensation at the section manager level and only about 5% further down. Against this, any Japanese regular employee, even production workers and assistants to section managers, will receive bonus payments normally amounting to about one-fourth of annual compensation. This makes it clear that the myth of seniority wages has a very shaky foundation.

In the above light, to what extent is the pay system in Japan, which people are wont to criticize, actually different from the “normal” system? If in this way the differences in the practices of the two countries are mainly a matter of degree, how can it be said that the Japanese system is unlike the normal system? It seems to me that there is only one real difference, which is that Japanese firms do not clearly state their upper and lower limits on the range rates for each job grade. But while firms may not specify these limits in corporate rules, they place an effective cap on the top of each range until an employee is promoted into the upper ranks, and rarely will an employee be granted a salary hike going beyond it. This feature of Japan’s pay systems, though, plays no part in the myth of seniority wages.

RESULTS OF MERIT RATINGS

The more astonishing aspect of the Japanese misunderstanding of American pay systems concerns the second point cited above, the assumption that pay varies greatly from one individual to the next. In fact Japanese pay systems may produce far greater salary differentials. There are two reasons for this.

One is the number of employees who are subject to merit ratings. Compared with American employees, far more Japanese have their work rated. White-collar workers in the United States are subject to merit ratings, but it appears that blue-collar workers are not rated in most cases, although I cannot cite any good data for this assumption. The classes of American workers receiving ratings have been growing, but they evidently are still a minority in the workforce. Merit ratings are not performed on workers who are members of labor unions, and they are not common even when workers do not belong to a union.

In Japan, by contrast, it is hard to find any regular employee who is not subject to merit ratings. This is true of all large corporations, of course, but it is also the case in small and medium-sized firms. The only workers who are not subject to merit ratings are the part-timers, temporary staff members, and other such nonregular employees. Companies have been taking on more nonregular workers, but even among blue-collar personnel, they appear to still be in the minority. In this way, differentials in pay resulting from merit ratings should be far more common in Japan than in the United States.

The second reason concerns the extent to which the results of merit ratings separate individuals. Most Japanese would tell you that the American ratings must produce wide variation in results, but the Japanese ratings only small ones. Actually this is an extremely difficult subject to investigate. One needs to compare the pay of workers who may vary greatly in their abilities but are similar in other respects, such as years of employment and job grade. An inquiry of this type would examine the personnel records of individual employees working for a single company, but this is data that companies do not release. Such records are not disclosed even within companies, so you cannot get answers to your questions by talking with employees.

As it turns out, however, some excellent studies drawing on a wealth of data have been conducted. Many are American studies, as the United States is a country in which specialists are highly respected. Naturally enough, the findings of this first-rate American research have been carried in leading economic journals. I have come across several of these studies, and the conclusions they reach show no substantial disagreement. To be sure, they rely on data that is now somewhat old. But these are multiyear studies, which understandably cannot always incorporate the latest data, and in any event it seems unlikely that the trends revealed by the meticulous analyses have recently changed. A number of similar studies have also been conducted in Japan, and when we compare the findings, a conspicuous difference can be seen.

It turns out that differentials in the results of merit ratings are wider in Japan than in the United States. In both countries the ratings normally rank the worker in one of five grades. In the American systems, about 95% of the employees are given ratings in just two of the categories, grades 3 and 4, but in the Japanese systems, the rating results are spread more widely among all five grades. The personnel divisions of Japanese corporations release guidelines on how the ratings are to be conducted, and the personnel carrying out the ratings follow these instructions faithfully.

It would be dangerous to assume that the wide scattering of Japan’s rating results provides an accurate picture of differences in merit. An alternative explanation could be that the widely spread ratings are largely a reflection of the number of years of employment. In that case they would not represent true differences in the merits of individual workers, since all workers could expect to rise toward the top grade as the years of their employment lengthened. Two of the Japanese studies looked closely into this question, and what they found was that when the ratings measured how competent the employees were rather than how long they had been employed, they had a stronger impact on pay amounts. This is understandable. That is, in any corporate hierarchy the number of posts available rapidly diminishes as one moves toward the top, and more and more employees become unable to win further promotions based only on length of service. For the ratings of older employees to be of use in deciding on promotions, they have to take into account other criteria, such as how well the employees are acquitting themselves.

In this light, the competition among employees may become even more intense in Japanese firms than in American ones. Or perhaps I should say that as they rise in the ranks, many Japanese find themselves being sucked into such competition whether they like it or not.

ASSESSING THE LOSSES

What are the losses resulting from the myth of seniority wages and from the reforms of Japanese salaries based on a misunderstanding of how Western pay systems actually operate? Here I would call attention to two areas of damage.

The first is the damage from misguided reform efforts to the fostering of high-level human resources. If a company’s work involved only repetitive tasks, workers would become relatively proficient in just a few days. Once they mastered the routine, their efficiency would never get much better. In a high-wage country like Japan, however, business firms cannot come out on top in global competition if they devote themselves to this kind of work. The only way they can retain a competitive edge is to tackle sophisticated work assignments with highly talented workers. But what is the sophisticated work these highly capable employees need to handle? Let us take the case of the personnel section manager once again. If the work of this manager could be fully prescribed in a manual, there would be little point in creating such a post. One might just as well program a computer to take over the job. The reason for having a human being head the personnel section is that problems and changes that cannot be anticipated arrive one after another, and it is crucial that there be a person in charge who can deal with them capably.

One example of the kind of work such a person may need to address is reform of the salary system. What are the desired changes, and what practices should be left untouched? Generally Japanese personnel look to see what other companies in their industry are doing, and they also keep an eye on trends in domestic opinion. Underlying this, though, is the perception of what is normal in the rest of the world, especially the United States and Western Europe. Is the perception that has formed just within one’s industry sufficient for designing a salary reform? If not, how does one go about arriving at a better understanding?

No doubt the correct answer to the last question is that one should draw on high-quality surveys and studies. But how does one go about finding such research and determining whether its quality is good? In all such quests, the best searcher is a person with common sense and penetrating discernment based on practical business experience. This person must be able to make sensible judgments after considering the options, rejecting some ideas as unsound and pointing out the problem points in others. The issues to be considered in salary reform are limitless. But because the success or failure of the reform will depend on how skillfully the issues are handled, the company must put an outstanding individual in the post of personnel section manager.

How does a company acquire a truly talented personnel section manager? Outstanding individuals start out with outstanding potential abilities. If they already had fully developed abilities, they would be ready to produce good results in whatever post they were assigned. The supply of labor with outstanding potential is, however, quite limited everywhere. In addition, Japanese corporations at present are concentrating their efforts on the overseas operations in which they are making direct investments, and because Japan is a latecomer in the world’s markets, many members of its elite have already been hired away by American and European corporations.

So what is a company to do? I would suggest that the path to take is developing the abilities of its middle-management personnel. This is a promising way to secure talent for the business divisions in Japan as well as overseas. Above all, middle management is a deep stratum in Japanese firms, one with abundant personnel. If the abilities of this group can be developed, the effects on corporate operations should be huge.

That leads us to the question of how abilities can be improved. Here, undoubtedly the correct way to proceed is to make effective use of personnel who have acquired practical experience. To be more specific, the company should groom managers by giving them a broad range of practical experience in posts closely related to the position it wishes to fill. Such individuals would be able to draw on their experience when problems of one sort or another cropped up, and in rising to meet challenges, they would polish their skills. Among middle managers with equivalent potential abilities, the one who will flower the fastest as head of the personnel section will be a person who has already served as manager of, for instance, the recruitment and salary sections.

From this perspective, we can see where the reforms of the pay system went wrong. If a firm’s goal is to foster middle managers with broad practical experience, the pay-for-job system is not the right choice. The pay-for-job-grade system is best. And it will be even better if the firm has a range rate system for its section managers, since pay hikes within the range will encourage these managers to broaden their experience at their level of management.

SENDING THE WRONG MESSAGE

The other area of damage is a failure in communication when Japanese affiliates overseas advertise that they make use of the seniority wage system. Such damage is already occurring, and it is likely to become more serious. While I cannot fully explore this point because of limited space, I would emphasize that overseas operations have become vital to our country. These days the earnings from overseas investment have a far more profound impact on employment and living conditions within Japan than do profits from exports. A vital part of this income is that derived from direct investment in overseas plants and other business operations. To make these operations even more profitable, Japanese affiliates need to help their local employees improve their skills so that they can work even better.

The pay systems used at these affiliates are of critical importance. But if local personnel are told only that their compensation comes in the form of seniority wages, they will not understand. In fact, they may make the mistaken assumption that even if their performance is poor, they are still guaranteed wage hikes year after year, with no major pay gap between themselves and those who work harder, as long as they stick with the company. If that is their thinking, they will not be motivated to improve their abilities.

The overseas affiliates can, of course, set down on paper a comprehensive explanation of how salary amounts are calculated. However, local workers are apt to put little faith in what they read in corporate documents. Only after seeing many examples of how the system works will they gain confidence in it. More than that, providing an adequate written explanation of the details of the pay system for all conceivable cases is no easy matter. It would make more sense simply to tell the local recruits that wage payments will conform to global standards. If they happen to have changed their system to a pay-for-job one, they need merely change it back to the pay-for-job-grade format, which is the normal practice. As anybody can understand what a global standard is, even if its minute provisions are not specified, workers will be encouraged to improve their abilities, knowing that they will be compensated for what they achieve.

THE ROLE OF GOVERNMENT

Now let us consider one of the myths in the broader sphere of the economy: This is the notion that the Japanese economy has grown powerful because the government has given it far more help than Western governments give their economies. When we turn our gaze back to the economy’s takeoff before World War II, however, we find that this was not the case. In those days the nation’s most important industry was cotton spinning, and textiles accounted for more than half the employment in the manufacturing sector. But the leading firms in this sector were private enterprises operating without government help.

It is true that the government was involved in the launch of cotton spinning. The first spinning operations were run or subsidized by the central government or the larger feudal domains (han). However, almost all these enterprises ended in failure. By the time the industry was growing powerful and gaining prominence in the world, all the main firms were totally private, and they did not even rely on foreign specialists. And yet they were able to win in competition with cotton-spinning firms of Britain and the United States.

At the time of Japan’s takeoff, Western countries with the exception of Britain were imposing high tariffs in the name of fostering infant industries. This is where government authority was then being exercised. The countries of Asia, though, were unable to act independently on this matter, since the Western powers did not allow them to set tariffs on their own. As a result, Japan was able to apply tariffs of only about 5% at most. Even though Japanese textiles were not protected against imports, however, the industry managed to prosper.

Japan’s economists used to take it for granted that the country’s low wages were the reason for the success of this industry. But China and India then had wages even lower than Japan’s, and though both had factory-based spinning firms that enjoyed strong growth for a while, their industries eventually stagnated. Since the Japanese industry alone continued to grow, clearly more than low wages was involved.

When we look into the circumstances of the Japanese industry, an orthodox explanation comes to light: technological development. In those days a recently improved method of ring spinning was the vanguard technology for spinning fibers to make yarn, and Japanese firms acted faster than American and British firms to introduce machines based on this method. The Japanese firms then concentrated on coming up with ways to mix various kinds of cotton from different places, raise productivity, and in other ways make further improvements on the technological side. For instance, since inexpensive cotton thread tends to break easily when being pulled by drafting rollers, fine adjustments must be made in a variety of conditions, such as temperature and humidity, in order to prevent breakage from hurting productivity. Were it not for the advances on this front, the Japanese industry would have followed the Chinese and Indian industries into decline.

KNOW YOURSELF AND YOUR ENEMY

One of the harmful effects of the exaggerated notion of the government’s role is that the private sector has come to shoulder the load even in areas where the government ought to be doing more. Here the funding of research and development is a case in point. Believing that it was not proper for the government to be playing such a prominent role in business affairs, the authorities scaled back their R&D spending. But the result is that Japan has become a country in which government funds account for only a small share of R&D expenditures. Since the 1990s this share has been in the vicinity of 20%, whereas Western governments supply some 50%–60% of R&D funding.

Here we find another way in which myths can cause damage. When researchers undertake creative work, the chance of achieving success diminishes the more creative the endeavors are, and the risk of failure rises. It is said that in the world’s pharmaceutical industries there are 5,000 failures for each success. These are, moreover, long-term projects that may take 5 or 10 years to complete. In the area of basic research, which is highly risky and requires long-term work, relying on government funds is only natural. Thus far, thanks to strenuous efforts, Japan’s private-sector researchers have managed to match or top the results of their counterparts overseas, but there is reason to worry whether they can keep this up. Government funding on the level normal in other countries is to be desired.

How can we go about freeing ourselves from the shackles of such myths? Because many are byproducts of misperceptions of other countries, developing a correct understanding will be helpful. This can be done by unearthing and carefully examining studies that directly compare countries in equivalent depth using a single methodology. Research of this type is surprisingly scarce. More normal are studies that look closely at the workplaces in a single country and rely on the existing literature to draw comparisons with workplaces in other countries. This, though, runs the danger of allowing preconceived notions to bias the conclusions. When an exhaustive search is conducted, however, high-caliber comparative studies can be found.

This approach is what the famous Chinese military strategist Sun Tzu recommended: “If you know both yourself and your enemy, you can win 100 battles without a single loss.” It is not that easy, however, to know yourself and others. I will conclude with two cautions on this point. First, you will not always find what is important about a society written in the documents available. Often you need to conduct analyses of practices that have not been put into writing. Second, what is important about a society cannot always be expressed in quantitative terms. Elements that defy quantitative analysis also bear careful attention. The best comparative studies, then, are those that try to overcome the limitations in these two respects.

Translated from an original article in Japanese written for Japan Echo.

© 2009 Japan Echo Inc.