In my book Trinity Model of Management, which was the starting point of this project, I suggested that Japanese companies should take more risk in a sophisticated way (and earn high returns as a result). This suggestion is due to the fact that the level of risk that the Japanese companies take is markedly lower than their counterparts in other countries. In order to overcome this, I proposed that all the stakeholders in the same boat should hold equity as an incentive, and accumulate wealth by increasing profitability and firm value by integrating the ideas and skills of highly selected investors into management (Note 1).
In this article, I once again present empirical data regarding the level of risk-taking by Japanese companies and look into the structural factors behind their risk-taking attitude. The conclusion of my analysis is to encourage sophisticated risk-taking. For the objective of "everyone becoming wealthy together," it seems insufficient to approach this challenge from only the equity side. My suggestion is therefore to approach this challenge from the debt side, and in particular, to implement corporate pension reform.
1. Current Status of Risk-Taking by Japanese Companies
In recent years, the perception that the level of risk-taking by Japanese companies is low has become common. For example, on January 25, 2019, Nihon Keizai Shimbun ran an article pointing out the low level of risk-taking by Japanese companies through an international comparison (Note 2). The article contained the following section, which describes the risk-averse nature of Japanese companies' investment behavior, including their preference for cash holdings and the tendency to avoid risk regarding investment in research and development (R&D).
"The glut of money in developed countries has become evident…The total value of funds on hand held by Japanese, U.S. and European companies came to 470 trillion yen in fiscal 2017...While the cause is a reduced allocation of funds toward capital investment, Japanese companies' cautious attitude is particularly notable...They are unable to adopt an optimistic mindset despite being aware that investment is necessary for growth...Japan lags behind in R&D expenditure, on which future growth potential depends…In the United States, R&D expenditure in fiscal 2017 increased 77% compared with 10 years ago. The increase in Japan was 17%. A decade ago, the ratio of R&D expenditure to sales was 2.1% in the United States and 2.2% in Japan, but now, the ratio is higher in the United States, at 2.7%, against 2.2% in Japan. The perception that the United States focuses on short-term profit while Japan aims for growth from a long-term perspective is outdated."
The above-mentioned article in Nihon Keizai Shimbun is not only focused on R&D expenditure. It confirmed that Japanese companies are risk-averse with respect to capital investment as well. Table 1 shows the percentage of companies that reduced capital investment year-on-year of the total number of listed companies in the period from 1985 to 2009 in Japan, the United States, the United Kingdom, Canada, Germany, France and South Korea (Note 3).
In addition to the average percentage of companies that reduced capital investment in the entire period from 1985 to 2009, the table provides the figures for each five-year period, namely 1985-1989, 1990-1994, 1995-1999, 2000-2004, and 2005-2009. For example, 47.1% of Japanese companies reduced capital investment over the entire period, while 40.5% did so in 1985-1989. Table 1 clarifies the following three points.
First, the percentage of companies that reduced capital investment over the entire period did not vary much across countries. In the entire period, the average percentage of companies that reduced capital investment was around 45%, and in all countries, the percentage was within the 40-49% range. In other words, there was no significant difference across countries in terms of companies' tendencies to reduce capital investment. Second, Japan had the highest percentage of companies that reduced capital investment over the entire period, with 47.1%. Third, data for the 1985-1989 period is particularly noteworthy. In this period, Japanese companies exhibited a high level of international competitiveness, while U.S. companies were losing competitiveness. However, even in this period, Japan had a higher percentage of companies that were reducing capital investment than the United States, at 40.5% and 39.0%, respectively.
Those facts indicate that as a general rule (regardless of economic cycles), Japanese companies have the strongest tendency to reduce investment among the listed countries and are more risk averse.
Next, let us look at R&D investment. Table 2 shows an international comparison of year-on-year changes in the percentage of companies that reduced R&D expenditure.
In Table 2, there are four noteworthy points. First, in the entire period, the percentage of companies that reduced R&D expenditure year-on-year varied relatively widely across countries. While the percentage of companies that reduced capital investment was in the 40-49% range in all countries, the percentage of companies that reduced R&D expenditure ranged from the high 10% range to the low 40% range. Second, over the entire period, Japan had the highest percentage of companies that reduced R&D expenditure and the average percentage for the entire period was higher than 40%, whereas the percentage was lower than 40% in all other countries. Third, the average percentage of companies that reduced R&D expenditure over the entire period in the United States was 22.5% and was the second-lowest after Canada, with 19.1%. Fourth, even in the latter half of the 1980s, when Japanese companies had a high level of international competitiveness, the tendency to reduce R&D expenditure was stronger in Japan than in any other country, whereas U.S. companies were less likely to reduce R&D expenditure.
Those facts indicate that as a general rule, Japanese companies have the strongest tendency to reduce R&D expenditure (a barometer of long-term investment for the future) and are always risk-averse. That in turn suggests that Japanese companies are most pessimistic about the future. Moreover, given that the reduction of R&D expenditure (unlike the reduction of capital investment) directly helps to maintain or increase current profit due to the accounting treatment of the expenditure, it suggests the possibility that companies' management behavior in Japan may be the most short-term or nearsighted of all countries.
In any case, those two sets of data indicate that the level of risk-taking by Japanese companies remains low compared with companies in other countries. The strong tendency to reduce capital investment and R&D expenditure indicates less interest in suffering short-term pain for long-term gain than companies in other countries. This also strongly suggests that the popular perception that Japanese companies conduct business from a long-term perspective is wrong.
2. Structural Factors behind the Low Level of Risk-taking—Approach from the Debt Side
In Trinity Model of Management, I proposed a path for all managers, employees and shareholders to become wealthy together by ensuring that managers and employees hold more shares in their companies. I believe that having managers and employees hold shares helps to align their interests with the interests of shareholders and encourages them to become more willing to take risks, resulting in the situation where "everyone becomes wealthy together" due to increased profitability and firm value.
However, it is clear that the level of risk taking by Japanese companies is low, as was described in the previous section. In this section, let us look into why the level of risk-taking by Japanese companies is so low.
To state the conclusion first, behind the low level of risk-taking is Japanese companies' tendency to align their interests with the interests of creditors, who favor stable returns over risk-taking (rather than aligning their interests with the interests of shareholders, who aim to earn high returns by promoting high-risk strategies). In particular, this column pays attention to corporate pension funds, (which are often overlooked as creditors), rather than financial institutions and business partners (which are more commonly recognized as creditors), and explains how the presence of corporate pension funds as creditors affects the risk-taking attitude (Note 4).
First, I would like to compare the corporate bankruptcy procedures in Japan and the United States. In January 2010, Japan Airlines, Japan Airlines International and JAL Capital initiated a corporate rehabilitation procedure. Through this procedure, beneficiary rights to corporate pensions received stronger protection than financial institutions' debt claims. Financial institutions forgave general rehabilitation debts totaling 521.5 billion yen, which translated into a debt forgiveness ratio of 87.5%. In contrast, the reduction of total value of beneficiary rights to corporate pensions was much smaller: a reduction of around 50% for current JAL group workers who were members of the corporate pension plan and a reduction of around 30% for former JAL group employees with beneficiary rights, with the average reduction rate amounting to approximately 40%.
As is clear from this case, in Japan, controversy occurs over how to treat corporate pensions at the time of a corporate bankruptcy. On the other hand, in the United States, a bankruptcy procedure proceeds without argument. In fact, companies filing for Chapter 11 of the U.S. federal bankruptcy code is a relatively common occurrence in the United States. For example, in May 2020, Hertz Global Holdings, a major car rental company, filed a Chapter 11 application in response to the COVID-19 crisis. In the same month, Neiman Marcus Group, a high-end department store operator; JCPenney, a long-established department store; J.Crew Group, a major clothing retailer; and Gold's Gym International, which operates Gold's Gym fitness clubs; also filed Chapter 11 applications.
As described above, it is not unusual for a U.S. company to initiate a bankruptcy procedure. The differences between the situations of bankruptcy in Japan and the United States arise from differences between the prevailing pension systems and legal systems in the countries regarding the protection of pension beneficiary rights. Let us look at the differences in more detail.
Corporate pension plans can be divided into defined-contribution (DC) pension plans and defined-benefits (DB) pension plans. Under DC pension plans, employees pay fixed contributions, with the contributed funds managed under their individual accounts, and the status of pension assets and liabilities is not reflected in companies' financial statements. Among U.S. companies, DC pension plans are predominant.
On the other hand, under DB pension plans, the difference between the present value of retirement benefits liabilities to be paid to employees in the future and the value of pension assets is reflected in companies' balance sheets. As a general rule, DB pension plans are still predominant among Japanese companies. Usually, the value of retirement benefits liabilities is larger than the value of pension assets, and as a result, the value of unfunded pension liabilities, which represents the difference, is recorded in the balance sheet in many cases. The recording of pension liabilities in the balance sheet, which is absent under DC pension plans, may well affect the top management's day-to-day decision making in some way. In addition, in practice, the treatment of DB pension plans becomes a major point of discussion in bankruptcy procedures in Japan. Beneficiary rights to DB pensions are protected under the Defined-Benefit Corporate Pension Act. Under this law, companies are obligated to make a lump-sum payment of contributions to cover a pension reserve shortfall when abolishing their pension plans as a result of the dissolution of pension funds or for other reasons.
The lump-sum payment clause is applicable even before the initiation of a bankruptcy procedure. However, once a company initiates a legal liquidation procedure based on the Civil Rehabilitation Act or the Corporate Reorganization Act, the treatment of pension beneficiary rights changes. Under a procedure based on the Civil Rehabilitation Act, pension liabilities are placed outside of the framework of a rehabilitation plan and full payment is made to the employee, with their beneficiary rights remaining intact. On the other hand, if the Corporate Reorganization Act is applied, one third of the retirement benefits liabilities is classified as common benefit claims which will be paid fully to the beneficiary. The remaining two thirds are classified as preferred reorganization claims and the value of those claims may be reduced under a reorganization plan.
As is clear from the fact that liabilities relating to retirement benefits are recorded on the debt side of the balance sheet, a reserve shortfall is a liability for companies. Moreover, one notable feature of the protection of pension beneficiary rights in Japan is that companies have the payment obligation in a bankruptcy procedure both under the Civil Rehabilitation Act and the Corporate Reorganization Act.
In the United States, however, companies are not obligated to make a lump-sum payment of contributions, but the Pension Benefit Guaranty Corporation (PBGC) is responsible for protecting benefits. If a DB pension plan pension fund placed under PBGC's administration is dissolved, PBCG protects members' beneficiary rights to basic pensions. Similar payment guarantee systems are in place in other major developed countries, including Canada, the United Kingdom, Germany and Sweden (Ministry of Health, Labour and Welfare's Pension Bureau (2007) and Stewart (2007)).
A legal comparison of beneficiary rights in Japan and in the United States and Europe indicates that Japanese corporate pension plans are distinctive in that the payment obligation ultimately rests with companies while with the pension plans in the United States and European countries, PBCGs and similar organizations protect employees' beneficiary rights. In the United States and Europe, when companies initiate a bankruptcy procedure, they are exempted from the obligation to pay corporate pension benefits because pension beneficiary rights are protected under the payment guarantee system.
In Trinity Model of Management, I argued that shareholding by executives and employees should be promoted as a way of aligning their interests with the interests of shareholders. However, at most Japanese companies, DB pension plans still occupy an important role (although an increasing number of companies are introducing DC pension plans). This means that Japanese companies' executives and employees are creditors holding claims against the companies with respect to future pensions, and the companies are debtors. In other words, parts of compensation that executives and employees receive have a debt-like nature (Note 5) from the beginning, and therefore, their interests are not necessarily aligned with the interests of shareholders.
From another point of view, as Japanese companies' managers are, in some respect, representatives of organizations of workers (Note 6) their decision-making tends to emphasize the interests of employees, which are aligned with the interests of creditors.
The level of risk-taking by Japanese companies may remain low because of the combined effects of (i) the requirement of recording pension liabilities in the balance sheet under DB pension plans, (ii) the strength of legal obligations regarding corporate pension plans (which attracts attention in the event of an emergency such as corporate bankruptcy), and (iii) management behavior that emphasizes the interests of employees (whose relationships to the company are very similar to those of creditors). This is one of the structural factors behind the low level of risk-taking by Japanese companies, on which this article sheds light.
3. Challenges for Putting the Trinity Model of Management into Practice and Path to Solutions
As I argued in Trinity Model of Management, in order to achieve the objective in which "everyone becomes wealthy together," including managers, employees and shareholders, it is necessary to develop institutional systems designed to promote the holding of shares by managers and employees. In this respect, under the current Labor Standards Act, companies are required to pay salaries to employees in cash, and this requirement is a major obstacle to promoting the holding of shares by employees.
On the other hand, as this article explained, if Japanese companies are to be encouraged to see risk-taking as favorable, it is necessary not only to improve equity incentives but also to reform corporate pension systems, which provide a form of debt incentive. I conclude this article by proposing two paths for reform.
First, Japan, too, should introduce a payment guarantee system. At the time of a corporate bankruptcy, beneficiary rights to corporate pensions are protected if there is a payment guarantee system that protects unfunded pension liabilities. Companies are released from the obligation to pay corporate pension benefits to beneficiaries if they go bankrupt, and therefore, they are encouraged to see risk-taking as a positive. Although the introduction of a payment guarantee system requires legislation, it will become a pillar in resolving the problem of the low level of risk-taking by Japanese companies.
Second, retirement benefits liabilities recorded on the balance sheets of individual companies should be reduced. That will make it possible for the top management to give less priority to the interests of executives and employees as creditors in the decision-making process. Specifically, there are two ways to do that.
The first is to reduce the influence of DB pension plans under the corporate pension system by introducing DC pension plans in earnest. The introduction of DC pension plans lowers the risk of retirement benefits liabilities increasing in the future, thereby enabling companies to embrace risk-taking behavior. For example, Takeda Pharmaceutical acquired Millennium Pharmaceuticals in 2008 and Nycomed in 2011, after introducing a DC pension plan in 2007.
The other way is to make cash contributions cover unfunded corporate pension liabilities. In Japan, there are many cash-rich companies. If companies have surplus cash on hand, it is worth considering having them make cash contributions to cover unfunded corporate pension liabilities, rather than returning profits to shareholders. Doing so may align the interests of employees with the interests of shareholders in the long term by reducing the impact of corporate pensions on the debt side.
In any case, in order to put the trinity model of management into practice and encourage Japanese companies to take risks, it is not only essential to foster a positive attitude toward earning returns by ensuring that managers and employees hold equity incentives, but also to dispel managers' fears about risk-taking by reducing debt incentives/disincentives, which tie the hands of Japanese companies.
^ An international comparison by Acharya, et al. (2011) also showed that the level of risk-taking by companies in Japan is the lowest among companies from the 50 or so countries compared, if measured in terms of cashflow volatility.
^ "Glut of Money in Japan, U.S., Europe Becomes Evident Amid Competition between Global Data Analysis Companies—Japan Lagging Behind in R&D, " a front-page article in the morning edition of Nihon Keizai Shimbun, January 25, 2019.
Acharya, V. V., Y. Amihud, and L. Litov, (2011). "Creditor Rights and Corporate Risk-Taking," Journal of Financial Economics, Vol.102 No.1, pp.150-166.
Stewart, F., (2007), "Benefit Security Pension Fund Guarantee Schemes," OECD Working Papers on Insurance and Private Pensions, No. 5.
Pension Bureau, Ministry of Health, Labour and Welfare (2007) "Regarding Risk Management under Corporate Pension Plans" (the eighth meeting of the Corporate Pension Study Group, Reference Material 5, April 27, 2007).
Imai, K. and Komiya, R. (1989) "Characteristics of Japanese Companies," Imai, K. and Komiya, R. (Eds), Companies in Japan, University of Tokyo Press, pp. 3-26.
Noma, M. (2010) "Why Has Japanese Companies' Competitiveness Failed to Be Restored? Counterargument against Two Popular Theories Regarding Dividend Payment and Investment Behavior," Hitotsubashi Business Review, Vol. 58 No. 2, pp.74-89.
Noma, M. (2020) Retirement Benefits Liabilities and Corporate behavior—Empirical Analysis Regarding Internal Liabilities, Chuokeizai-sha.