Creating an Employment System that Provides Hope for the Future and the Role of Employers - Moving Beyond Arguments over Performance- Versus Seniority-based Systems

TSURU Kotaro
Fellow, RIETI

For the sake of simplicity, let's say the downturn in stock prices in early 1990 was the beginning of the bursting of Japan's economic bubble. This year, 15 years later, is likely to be a turning point for the Japanese economy. Signs are emerging that a range of problems that have overshadowed the Japanese economy - nonperforming loans (NPLs), financial woes and debt overhang - is finally coming to an end. It may take some time before these problems, including NPLs held by local financial institutions, are fully resolved, but it is certain the Japanese economy is moving out of its quagmire of financial problems and entering a new phase.

Key issues facing the Japanese economy: human resource development, working patterns and organizational structure

As we look at the future of the Japanese economy, the key questions that must be asked are how to nurture human resources, how work patterns are shifting, and how the structure of the economy should be redesigned. To be sure, Japan has a number of pressing issues apart from financial problems that must be addressed. Nevertheless, human resources and organizational issues deserve special attention because it is difficult to detect and share an objective view on changes in these areas.

Although objective indicators and data on human resources and organizational structure are available, changes are much slower to appear and more difficult to detect than changes in other aspects of the economy. By the time problems are obvious to everyone, the situation may have reached the point of no return. It is thus all the more important to plan well ahead and act quickly in dealing with human resources and organizational problems.

This view appears to be gradually taking hold among experts. For instance, books dealing with labor issues ranked high on the list of the top 30 books on economics in 2004, according to an annual year-end survey sponsored by a business weekly. Two books in particular, which examine problems in the performance-based personnel management system, have attracted tremendous attention (see note 1). Since the mid-1990s, a number of books have been published touting the virtues of introducing an annual salary system and performance-based pay systems to Japanese companies. Underlying their arguments is the notion that Japan's traditional lifetime employment and seniority-based wage systems are outdated and should be replaced by a performance-based annual remuneration system, which is said to be superior in terms getting the most from employees. The two books mentioned above, which clearly point out problems with the performance-based system, have struck a chord with a number of Japanese readers who have been vaguely aware of these problems but unable to articulate them. It seems to me, however, that debates about the employment system are overly swayed by changing sentiments.

Both the conventional Japanese employment system and the performance-based system have their strengths and weaknesses; and which system is "better" depends upon conditions, making a discussion of the comparative merits of the two systems meaningless. Japan's lifetime employment and seniority-based systems, in essence, translate to a greater propensity for long-term employment and deferred remuneration (the wage-age curve shifts sharply upward toward the end of one's career) in Japan than in other industrialized countries. Underpinning these systems was continuous high growth on both the macroeconomic and microeconomic levels, and the pyramid-shaped age distribution of employees (an abundance of young workers). These factors enabled Japanese companies to pay higher-than-performance wages to middle-aged and older employees through an internal redistribution of resources. Also, employers and employees shared expectations that wages would steadily increase in the future.

However, the situation changed drastically in the 1990s. First, the potential and expected growth rates of the Japanese economy declined sharply. Second, postwar baby boomers, popularly referred to as the dankai ("lump") generation, reached middle age, causing a bulge in age distribution pyramid. Third, another big lump, those hired during the bubble years, will soon reach middle age. Companies now find it extremely difficult to keep to their commitments under the "deferred wage payment system," an implicit promise to pay higher wages to employees in the future in return for remaing with the company for a long period of time. Many major Japanese companies felt that the cost of labor had become disproportionately heavy, relative to total cost or profits, during the prolonged economic slump. Their response was to drastically reduce hiring of new new graduates in order to protect the jobs of middle-aged and older employees as much as possible. Companies increasingly turned to low-cost non-regular employees to fill vacancies. This, in turn, has led to the problem of youth joblessness or "neets" - referring to young people who are "not in employment, education or training."

Meanwhile, many Japanese companies, particularly major ones, began introducing annual salary systems in the mid-1990s in order to hold down the relatively high wages of middle-aged and older employees in return for letting them keep their jobs. In other words, in Japan, the performance-based annual salary system was introduced as a means to suppress the otherwise sharply increasing wages of middle-aged and older employees.

The performance-based pay system, insofar as it directly links remuneration to individual employees' performance, presents a number problems from an economic standpoint: Is it possible to objectively measure employees' performance? For those engaged in sales, it is relatively easy to measure each employee's performance, but it is almost impossible to measure the contribution of employees performing tasks that require teamwork. In other words, it is not always possible to verify the performance of each employee. As a result, there is an incentive for employers to underrate employees' performance so as to keep the cost of labor down. Obviously, such a bias becomes stronger when the suppression of wages is the very purpose of introducing the performance-based system, as is the case in Japan.

Employees, for their part, become inclined to prioritize, if given a choice, tasks or aspects of a job for which they are more likely to receive an objective evaluation. For instance, they will tend to prefer tasks that produce results in a shot period of time, or they will focus on the volume rather than the quality of their work. Furthermore, in cases where an employee's performance is evaluated based on how successful he or she is in achieving stated goals, employees are motivated to set their goals low whereas employers try to impose higher goals on them (the "ratchet effect"). If a company gives up on providing objective evaluations, and instead relies primarily on subjective evaluation by immediate supervisors, bootlicking by subordinates and favoritism by supervisors becomes rampant.

How to create an "acceptable" evaluation system

As discussed above, in reality, it is no easy task to objectively evaluate individual employees' performance and directly link such evaluation to the pay they receive. But this does not obviate the need for performance evaluation as part of a personnel management system. The key question is how and whether Japanese companies can develop a performance evaluation system that is acceptable to both employers and employees. The traditional evaluation system, typically used by major Japanese companies operating under lifetime employment and seniority-based wages, assesses individual employees' performance over a long period and offers important posts rather than wage hikes as a reward for good performance. Under this system, a company makes little distinction in terms of wages and job status among those employed in the same year until about the 15th year of service. This helps to promote teamwork and maintain morale. In the meantime, the company rewards high performers by assigning them to positions that clearly mark them as "fast-track" or star employees. As an employee builds up a work history, a consensus on his or her performance is formed gradually and in a way that is obvious to everyone, thereby creating an environment where employees generally find their overall evaluation reasonable and impartial. This type of evaluation method also prevents unfair personnel decisions, such as giving high marks to an employee who has neither demonstrated sufficient competence nor produced results. To appoint such an incompetent to a key post would have a huge negative impact on the whole organization and the management would eventually be forced to pay the cost for its bad decision. Those opposed to the performance-based system, which is based on the notion of money as the single most important motive for work, typically say that people work for a sense of fulfillment rather than money. From their point of view, an evaluation system that provides an interesting post as reward is a reasonable system that appeals to people's desire to take up challenging tasks. But such an evaluation system is workable only if companies maintain their annual recruitment of new graduates for lifetime employment. Given the reality of today's workplace and labor market (i.e., the presence of employees with various work styles and the increasing mobility of labor), it is difficult to maintain a performance evaluation system based on a series of posts held over a long period of time.

It is no surprise the performance-based system, which was introduced for the (unstated) purpose of suppressing the wages of middle-aged and older employees, failed to work. At the same time, however, returning to the old regime of lifetime employment and seniority-based wages does not provide an answer to the problems facing Japan today because the country has undergone drastic changes since the mid-1990s. A fundamental rethink is likely needed in order to design new employment and personnel evaluation systems. The reason why performance evaluation needs to be explicitly linked to some sort of reward, whether it is remuneration or the type of post offered, is to motivate employees in their work. The tacit assumption is that employees without explicit incentives will easily lose their enthusiasm for work and stop working hard because they do not share the same goals as their employers.

In an era of uncertainty, it is all the more necessary to define the corporate mission and make it known to employees

If employers and employees can be made to share the same goals, there is little need to think about work incentives. The management of a company must clearly define the corporate mission and ensure that all employees take it to heart. For instance, a company and its employees must be able to share, in concrete terms, the "thoughts" and "dreams" underlying the kinds of products or services they want to deliver to customers. Of course, the ultimate goal of corporate management is to maximize profits and companies that fail to pursue this goal are doomed to go out of business. However, if the maximization of profits is the sole goal and mission of a company, its employees are not likely to derive a sense of pride and worth in what they do. In this regard, a corporate mission must go beyond - but not contradict - the goal of maximization of profits so as to provide employees with a sense of fulfillment at work.

There is a difference, however, between making sure employees understand the corporate mission and demanding their loyalty to the company as a "community bound together by a common destiny" under the lifetime employment system. In order to manage a "portfolio" of employees with diverse backgrounds and expertise, regardless of whether they are employed as new graduates or in mid-career, and shape them into a capable workforce, the company's mission must be the one that employees find appealing from their own point of view. Also, in promoting the mission to employees, it is important for the management to try, with a sense of caring, to hold a dialogue with these diverse individuals so as to understand their situation and frame of mind. The communication of a corporate mission cannot be accomplished on the strength of a single charismatic leader. A corporate mission begins to permeate only after it becomes part of the company's "DNA," having been passed down from one generation of leadership to the next and transformed into a corporate culture.

In one of the books criticizing the performance-based system (see note 2), the author points out that in order to motivate people to work, people need to know the roles they are expected to play, how they can contribute to a company's mission, and what future awaits them as a result of their contribution. The key question, according to the author, is whether or not people can anticipate a bright future. Today we live in an era of great uncertainty. Whether companies can keep their employees motivated to work for the future hinges on whether or not they can present a well-established corporate mission that is shared by all their members - one that encompasses the past, present and future.

January 11, 2005


  1. TAKAHASHI, Nobuo (2004), Kyomo no seika shugi: Nihon-gata nenko seido fukkatsu no susume (The Emptiness and Delusions of the Performance-based System: Revive the Japanese-style Seniority-based System), Nikkei BP.
    JO, Shigeyuki (2004), Uchigawa kara mita Fujitsu: "Seika shugi" no hokai (An Inside Look at Fujitsu: The Collapse of the "Performance-based System"), Kobunsha.
  2. Jo (2004) op. cit., p.186.

January 11, 2005