How CEOs steal from your 401(k) © Erik Dreyer/Getty Images

Extra3/2/2009 12:01 AM ET

How CEOs steal from your 401(k)

The fat cats now keep almost 10% of profits for themselves, siphoning off money that could've boosted the share prices of the stocks you hold. And the worst of them may take much more.

By Kathy Kristof
MSN Money

Did a gang of greedy CEOs make off with your 401(k)?

A surprising number of seasoned experts maintain they did -- or at least could be held responsible for a substantial amount of your losses.

Now, as the Obama administration attempts to rein in executive pay for companies that take tax dollars in bailouts, it's worth considering how that pay affects everyday investors trying to save for retirement.

Pay's impact on profits

"CEOs look at public companies like personal ATMs," said Daniel Pedrotty, the director of the office of investment at the AFL-CIO, which represents members managing $300 billion in pension assets. "They (the companies) are machines from which they extract as much personal wealth as possible."

Pedrotty's comments may come off as union rhetoric, but Harvard law professor Lucian Bebchuk puts real dollars behind the claim. The top five officers at major U.S. public companies extracted roughly a half-trillion dollars in pay, stock and perks over the past 10 years, pocketing about 9% of average corporate profits.

That's up from about 5% of profits a decade earlier, Bebchuk said. And it doesn't include severance or retirement pay so rich that it can make a shareholder's eyes bleed. The problems:

  • Executive largesse siphons off profits that could have raised share prices. Americans invest roughly two-thirds of their 401(k) savings in stocks, which trade at a multiple of profits. A company that earns $2.20 a share might sell for $22 -- or 10 times annual profits, a fairly average multiple.

    If executives took a smaller slice, profits would be higher, and it's fair to assume share prices and 401(k) totals would be higher as well, said Paul Hodgson, a senior analyst with The Corporate Library, a research firm in Maine. How much higher is impossible to say, but "it's significant," Hodgson said.

  • Pay isn't tied to performance. Investors might forgive this if CEOs were being rewarded for raising profits. But that's often not how it works. Some of the most spectacular rewards of recent years went to CEOs of companies now near collapse. (See "As banks broke down, CEOs cashed in.")

    With performance falling through the floor, Bebchuk is scrambling to update his pay-versus-profit figures to see just how badly shareholders are being savaged. He suspects that the percentage of profits going to CEO paychecks has soared as the bear market and recession have shredded bottom lines.

  • Wild pay encourages bad behavior. Many watchdogs contend the lure of big paydays is part of what led bank and brokerage CEOs to encourage excessive risk taking, one of the causes of today's mortgage market meltdown. The resulting bear market has cost retirement savers $2 trillion and counting, The Wall Street Journal reports.

How do hefty paydays hit your 401(k)? Let's consider one shareholder horror story: KB Home (KBH, news, msgs).

A tale of 2 CEOs

In 2006, the Los Angeles home-building company's chief executive, Bruce Karatz, resigned after it and the Securities and Exchange Commission accused him of manipulating stock grants for executives.

But he'd done very well in 2005. Karatz's employment agreement promised he'd get between 1% and 2% of the company's pretax, pre-incentive-pay earnings.

In fact, his pay and perks amounted to a whopping $37.9 million. On an after-tax, after-paying-Karatz basis, he nipped 4.4% of the company's 2005 profits of $842 million. Add $118 million from the sale of stock options, and Karatz took home about 18% of what the company had earned.

At KB Home these days, Karatz's replacement, Jeffrey Mezger, presides over a mess. The real-estate market has collapsed, as has the company's stock price. A KB Home shareholder who bought $1,000 worth of shares five years ago has seen their value slip to around $290.

Mezger, like his predecessor, is also entitled to a portion of KB's pretax, pre-incentive-pay profits. But the company posted a $929 million loss in fiscal 2007, so this bonus amounted to nothing.

The CEO is still OK, though. His board awarded him a "discretionary" bonus of $6 million, and he ended up with total compensation of $16.4 million for the year.

In 2008, KB's board created a new standard for Mezger's performance awards, promising he'd get as much as $10 million if he just kept the company's losses below $300 million, according to documents filed with the SEC on Friday. KB's loss widened to $976 million in 2008. Mezger walked away with $9.6 million, including a $2.7 million bonus and $4.6 million in stock.

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Can't walk away easily

So how does KB Home affect your 401(k)? Well, you probably own a piece of it.

If you have part of your retirement savings in a fund that mirrors the Standard & Poor's 500 Index ($INX) -- the most common type of index fund -- you've got shares in KB Home whether you like it or not. KB is among the 500 companies in that index.

Company 401(k) plans are increasingly dominated by index-based funds, which promise low overhead and returns that at least match the market. But they're tied to the stocks in an index; they can't pick and choose. As an S&P 500 member, it's probably in an array of other funds as well.

And there's the rub. Experts on both sides of the executive pay debate advise shareholders to "vote with their feet" and sell stock in companies where executive pay looks extreme. But if you invest through a 401(k), with a limited choice of funds, walking away isn't easy, said Amy Borrus, the deputy director of the Council of Institutional Investors.

Continued: The wrong rewards

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