Of all investment constituencies, mutual fund managers may have the most powerful tool to keep CEOs in line - nearly $4 trillion invested in U.S. equity securities.

Fund managers have begun to focus on CEO compensation packages and are increasingly critical of them, according to a recent survey by Pearl Meyer & Partners, a New York-based consulting firm dedicated to executive compensation strategies.

About 90% of the fund managers surveyed said that companies' pay practices factor into their investment decisions, up from just 58% when Pearl Meyer last conducted the survey in 1998. Regarding CEO pay levels, 70% of the fund managers said that they are currently excessive, whereas in 1998, only 33% found them to be excessive. The 33 survey respondents were equity mutual fund managers selected from Chicago-based Morningstar's 500 Source Book or ranked four or five stars by Morningstar.

"As the market gets a little tighter and performance for companies has been off starting at the end of 2000 and into 2001, CEO pay levels becomes more of an issue," said Jan Koors, a vice president at Pearl Meyer. "High pay to executives is never challenged when companies are doing well and stock prices are shooting up. It only becomes a problem when company returns begin to fall."

Although corporate earnings and stock prices have fallen, CEOs are earning far more money, according to Pearl Meyer's analysis of 200 firms. While the average CEO salary of $1 million has only risen about 6% over the past three years, CEOs' total compensation packages have increased significantly due to generous stock option plans, according to Pearl Meyer. In fact, salaries rose 15% to $1.2 million between 1998 and 2001, whereas total compensation including stock options rose 47% to $7.5 million, according to Pearl Meyer.

As a result, nearly 75% of the fund managers surveyed said that current option grant levels are higher than necessary. Further, 79% said that significant stock option holdings detract senior executives' attention to focus on short-term stock performance.

The down market and higher CEO compensation are, of course, not the only factors causing fund managers to focus on CEO pay. The recent events at Enron, Global Crossing and Worldcom have put nearly all of a firm's financial decisions under the microscope.

"I think there is a heightened awareness and sensitivity in all issues that appear on proxies, including stock options grants," said Burton Greenwald, an independent consultant in Philadelphia. "There is a widespread crisis of confidence in corporate America caused by a couple of bad examples out there."

The low confidence in corporate America by retail investors is one of the reasons why fund managers have become more critical of CEO compensation, Koors said. Perhaps even more importantly, investors are further pushing for managers to scrutinize executive practices because many of those firms have been forced to cut staff while CEO compensation has risen, she said.

"It goes beyond just the fund managers. There is a general heightened awareness of excess executive compensation packages caused by the general market conditions," Koors said. "A lot of companies have had to lay people off, and inevitably there is a comparison to what senior management is making."

The board at Fidelity Investments of Boston has responded to reports in recent months about grossly excessive CEO compensation. The firm is currently considering whether to withhold votes for directors at companies that excessively compensate executives, according to Anne Crowley, a spokeswoman for the firm [see MFMN 6/24/02]. According to the survey, most fund managers do not trust corporate directors to establish CEO compensation. Roughly 82% said that most directors are failing to do an effective job setting appropriate levels of CEO pay.

It is unclear if other firms will follow Fidelity's lead and take action beyond selling shares, Koors said. Many funds will more likely vote by selling shares, and others will hold stocks even after determining that CEO compensation is excessive simply for lack of a better investment with that factored in, she said.

"As a fund manager, if you're going to vote with your feet, you have to have someplace else to put the money," Koors said. "If executive compensation is a reason to sell company A, you have to have a company B that's a better investment."

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