Employees at Lockheed Martin Corp.’s F-16 Fighting Falcon jet ceremony to commemorate the 4,500th delivery of the plane in Fort Worth. Photographer: Mike Fuentes/Bloomberg

May 4 (Bloomberg) — Being laid off is bad enough. Seeing your 401(k) plan then vote for your boss’s mega-million-dollar compensation package — justified in part by his initiating voluntary reduction in executive ranks and other cost-cutting measures” — might tip anger into outrage.

Seeing a fund in a 401(k) plan approve executive compensation packages that reward executives for laying off employees — aka plan participants — is not uncommon. If you work at a major public company, and your retirement savings plan has an index fund, odds are it owns stock in your employer. Come proxy time, that gives it a vote in how senior executives at your company are paid. And most funds vote to approve management’s recommendations on executive pay.

For an example, look at Lockheed Martin, where some 8,000 employees got pink slips in the last two years. Chief Executive Officer Robert Stevens received $21.9 million in fiscal year 2010, according to the company’s April 2011 proxy statement, in part because he took the cost-cutting actions quoted above. By two estimates, from financial research firms Obermatt and GMI, at the time of the proxy, Stevens was one of the most overpaid CEOs in the U.S.

While the average company in the S&P 500 got an 87 percent approval rating on the compensation advisory vote in their proxy — known as a “say on pay” vote — Lockheed got a 69 percent approval rating from shareholders. The company was one of ten blue chips in the Fortune 100 to receive such a low approval rating.

Bucking the trend and approving the compensation package, as well as a new incentive package for CEO Stevens is the State Street S&P 500 Index fund in the company’s 401(k) plan — which many of those 8,000 laid-off employees likely owned.

Conflicts of Interest

Fund experts such as John Bogle have long argued there is a potential conflict of interest in mutual funds voting on compensation packages at companies where they manage or want to manage 401(k) funds. “The largest source of business for mutual fund groups is the 401(k) business,” says Jackie Cook, founder of Fund Votes, a Vancouver, Canada-based proxy voting research firm. “Fund companies’ main challenge is not to impress employees but to impress corporate managements who administer these plans. So it’s not rocket science that mutual funds skew their proxy voting in favor of management.”

SSgA Funds Management and Lockheed Martin declined to comment for this article, save for an e-mail response from SSgA spokeswoman Arlene Roberts stating that in the case of Lockheed Martin SSgA strictly adhered to the conflict of interest policy outlined in its proxy voting policy.

In 2011, Fund Votes, in conjunction with union the American Federation of State, County and Municipal Employees (AFSCME), studied how the 26 largest fund families voted on proxies relating to executive compensation. It found that funds supported management compensation proposals 80 percent of the time. By contrast, funds voted in favor of shareholder proposals that would limit executive pay 48 percent of the time.

The three largest fund families — Vanguard, Fidelity and American Funds — voted 97 percent of the time against such shareholder proposals. Since those three companies controlled 59 percent of the assets of the fund companies reviewed in the report, they stood to benefit the most from companies’ 401(k) business.

Say on Pay

In Lockheed’s case, the difference between fund families that sell their products in Lockheed’s 401(k) and those that own Lockheed stock but aren’t in the plan is marked. On the say-on-pay vote, an average of 30 percent of votes cast by large U.S. mutual fund families were against it, Cook says. Of the seven fund families in Lockheed’s 401(k), only American Funds voted against it. (The vote was split, as some American Funds supported the resolution.) American Funds’ Investment Company of America Fund, the only American Fund which both owns shares of Lockheed and is in its 401(k), voted for management’s say on pay proposal, although it voted against Stevens’ incentive package.

Since Lockheed cited successful cost-cutting as a determining factor for Stevens’ compensation, one could argue that employees who invest in State Street’s S&P 500 Index fund or Investment Company of America are effectively paying management fees to funds that encourage their bosses to fire them. After all, labor is one of every company’s biggest costs. “I don’t think most employees are aware of this irony that their own investments are being used against their best interests,” says Fund Votes’ Cook.

Laura Lutton, the editorial director at Morningstar who oversees fund stewardship grades, says while funds rarely vote against management, looking at a fund’s proxy voting habits wouldn’t be on the top of my list when figuring out what’s a good fund to own. For the average shareholder investing through a 401(k), she says, it’s more important to have a manager running that fund who is well-established, has delivered good results in the past and is charging a fair fee.

Compensation Cap

Not every fund routinely votes with management. “We have an absolute cap on compensation,” says Adam Kanzer, who oversees proxy voting at Domini Funds, a socially responsible fund shop. If a CEO makes more than $10 million, the fund shop just votes against it. Above a certain amount the pay package isolates the executive from employees, the real world, shareholders, everything, says Kanzer. I understand you have to compete for talent, but I’d rather see the company find an executive really committed to the company and its long-term success than a pay package.”

The say-on-pay vote is what is known in securities’ law as a “non-binding” vote that cannot be enforced. Unfavorable votes can make a difference, however, as companies seek to avoid bad publicity. “When you look at last year’s votes, with companies that had poor votes you see changes to their executive compensation this year, says John Keenan, a corporate governance analyst at AFSCME. Look at fund company Janus. Its say-on-pay vote failed last year. The CEO’s salary was reduced 70 percent as a result. They put a cap on his compensation at $10 million.”

Lockheed itself has instituted changes because of last year’s say-on-pay vote. The company’s new proxy states: “Recognizing that our say-on-pay approval level was less than we expected, we broadened our efforts to obtain stockholder feedback as part of the annual review of our executive compensation program. Management met or talked with 26 of our largest investors, who represent nearly half of the Corporation’s outstanding shares, to obtain feedback on the say-on-pay vote, executive compensation generally, and governance matters.”

Among the changes are tighter restrictions on executive jet perks, performance-based stock option bonuses that are tied to return on invested capital and a shift toward a narrower peer group in the defense industry for comparing executive compensation.

Yet CEO Stevens still made $25.4 million last year. Perhaps many Lockheed fund shareholders were not too insistent about cutting Stevens’ compensation, because the stock gained 20 percent in 2011. Although Lockheed’s earnings declined for the year, analysts liked that profit margins expanded because of the layoffs.

“Shareholders are often part of the problem and are very short-term oriented in their thinking,” says Kanzer. “I’ve heard from a lot of corporate executives that they get tons of pressure from shareholders, in particular analysts, to hit quarterly earnings targets, and that is preventing them from making longer-term investments.” That’s too bad, because making long-term investments often requires hiring employees instead of firing them.