(FORTUNE Magazine) – ''What you are seeing now is the development of enormous power without many effective limits.'' -- David Boies, lead attorney for Texaco, talking about pension funds.

HEADY DAYS are here for pension fund managers. Those former bookkeeper types who spent their careers in the backwaters of state treasuries and corporate cashiers' offices filling out proxy cards have been transformed by the sheer -- and rapidly growing -- size of the fortunes they oversee. Pension funds now own 25%, by value, of all corporate shares traded in the U.S. Because their holdings are concentrated in major companies, they own 50% of the shares traded on the New York Stock Exchange and 65% of the Standard & Poor's 500 stocks. As a result of their increasingly dominant position in the stock market and their pivotal role in proxy contests, pension fund managers have become power brokers, flexing their muscles in the corporate suite. Some just want company CEOs to pay them enough respect to meet with them and discuss management policies. Others are more threatening, even talking about gaining a seat on the board. This is not quite the news CEOs need. Already under closer scrutiny from outside directors and stalking corporate raiders, they now have to wonder just how far pension power will go. They aren't the only ones who should worry. Employees, present and retired, and other shareholders have a big stake too. They would do well to ask: ''Who's really running our company?'' And if pension fund managers are going to get a bigger role: ''What do they know and just whom do they represent anyway?'' These are not easy questions. Many of the biggest funds are so-called public funds -- they provide pension benefits for teachers and other public employees and commonly are run by elected officials or political appointees. New York State Comptroller Edward Regan, for instance, has sole voting authority for the state pension fund's holdings of 430 million shares of stock, worth $36 billion. That gives Regan a lot of bargaining power. Hoping to get his support, Carl Icahn called him a half dozen times in two days during his proxy fight against Texaco this spring. Regan wound up voting against him anyway. Even the most responsible of political figures may have trouble sorting out the interests of pension fund beneficiaries from all the other issues facing government and influencing the electorate -- for instance, whether a particular vote might anger a CEO considering an investment in the state. Yet it is these public fund managers who are mounting the biggest challenge to corporate governance. MANAGERS of so-called private pension funds -- those at individual companies -- have been less militant, but they too are awakening. At AT&T, vice president David Feldman finds himself lord of a pension fund empire worth $35 billion, roughly equal in size to the assets of the entire company. His decisions have an impact not only on AT&T's 300,000 employees and 100,000 pensioners but also on the millions of shareholders in the companies in which he invests. Says Feldman: ''On a day-to-day basis, you don't feel powerful, but in a proxy contest it takes only ten or 20 institutions to carry the vote. It's something we're all just beginning to grapple with.'' Ironically, at one time the bulk of these company-sponsored funds were managed in-house by the company's finance or benefits officers, over whom CEOs could have some influence in determining what investments the funds made and how their shares were voted. Then along came the Employee Retirement Income Security Act, better known as Erisa, which spelled out the legal liabilities of people investing fund assets (see box). Many CEOs wanted no part of that exposure to potential lawsuits over investment or proxy voting decisions and contracted with professional money management firms. Now any influence those corporate chieftains attempt to exert over investments and proxy votes may well be illegal under Erisa rules. The Labor Department, suspicious that such violations are widespread, is conducting a broad inquiry of proxy voting by the managers of pension funds in 23 recent corporate contests. One thing is clear. Pension fund growth so far has not shifted power to the workers and pensioners themselves. Fund managers aren't elected by these beneficiaries and don't answer directly to them. The professional money managers making the day-to-day investment decisions also have no substantial economic stake either in the companies sponsoring the pension plan or in those in which the fund is invested. Indeed, they might have a conflict if they did. That makes these managers subject to the same criticism lobbed at corporate executives and directors for having minimal personal holdings in their company. Yet fund managers' influence is expanding rapidly. And the smart CEO will be developing policies to deal with it, maybe even harness it to strengthen management's hand both in maintaining a long-term view of what's good for the company and in dealing with some public policy issues that affect business. Pension fund assets are growing twice as fast as the GNP. They already approach $1.8 trillion -- or $2.2 trillion if small company funds not ordinarily counted in official statistics are included. That's 13 times the total two decades ago, and by the year 2000 the assets are expected to reach $3.5 trillion. By then, if the share of those assets invested in common stock remains at the present 40%, the funds could own 50% of all corporate equity. An early effort to bring this financial strength to bear on corporate management began in 1984. California's then treasurer, the late Jesse Unruh, read that Texaco had paid $1.3 billion in greenmail to the Bass brothers. It so happened that the California Public Employees' Retirement System (Calpers) was Texaco's largest shareholder. ''Do you mean these people can elect to buy out one class of shareholder at $55 and leave the rest of us in at $35?'' Unruh asked the Calpers staff. Yes, they can, they told him. ''Like hell!'' said Unruh. Unruh joined with New York City Comptroller Harrison J. Goldin and New Jersey's head investment manager, Roland Machold, to form the Council of Institutional Investors, a group representing large public employee pension funds. Soon after, there were successive takeover bids for Phillips Petroleum, which Phillips attempted to deflect with a recapitalization plan. Unruh called together Goldin and Machold. The three met in Goldin's office in February of 1985. Unruh said, ''Guys, in this room we control the future of Phillips. We need only to vote the proxy.'' The group heard both sides out, then voted against the Phillips plan. Phillips lost and had to come up with a sweeter deal. Skip from those beginnings to the case most in the spotlight today. In the heat of the bitter proxy battle with Carl Icahn, Texaco Chief Executive James Kinnear made a promise to two people -- Ned Regan of the New York state and local employees' retirement fund, and Dale Hanson, who runs the $46 billion California system that Unruh first galvanized into action. Kinnear's promise was to sit down with representatives of public employee pension funds to discuss their participation in nominating directors. Hanson voted Calpers's 763,000 shares for Texaco. Regan followed suit with his three million. Says Hanson: ''This is a threshold thing. I want to be able to say we've gotten a director on the board.'' Texaco insiders don't believe that Kinnear will give the funds a seat. Yet Kinnear's conceding even to talk about board candidates has some CEOs bemoaning the precedent. They believe that making commitments to shareowner groups is foolish. ''Eventually that baggage can be harmful to what's good for all shareholders,'' says John Frazee Jr., chairman of Centel, a telecommunications company. He recently fought off Asher Edelman in a proxy battle. For reasons he hasn't made clear -- but probably because he doesn't want to appear to be seeking a seat for himself -- Regan has begun distancing himself from the director idea. He did not plan to attend the meeting with Texaco, which was tentatively set for late August. In fact, he now goes so far as to say, ''The current directors should be governing. I don't want anybody on the board.'' New York City's Goldin doesn't argue for a basic change in the way directors are chosen. But, he says, ''I do think you'll see an expanded sense of who should be included on the board.'' A representative of a special shareholder interest group, he adds, will give management comfort because it will know that it has available instantly a shareholder's point of view. Having special interests represented on the board isn't exactly new, considering that board seats often go to big individual holders, banks, and in rare cases labor leaders. For the most part, pension managers have concentrated their fire on trying to influence the outcome of proxy voting. Incited by an onslaught of greenmail payoffs and shark repellents adopted by companies during the takeover frenzy of the Eighties, these institutional investors see their rights under direct attack. Their holdings are so big that the funds have difficulty getting out of a stock at a decent price when they don't like what's going on -- unless, of course, a raider's tender offer gives them the opportunity. And that is just what many companies are changing bylaws to protect against. Says Sarah Teslik, who directs the institutional investor council Unruh helped to establish: ''We have two options. We can park our money and go to the beach. Or we can say, 'Fine. We're in this for the long term, so let's help corporations do better.' '' The council now represents 62 public employee pension funds with $300 billion in assets. Over the past two years pension funds have blasted dozens of companies with a barrage of shareholder resolutions opposing greenmail buyouts of corporate raiders and poison pill devices that permit a company to recapitalize and make itself less valuable should a takeover occur. The votes against management are mounting. According to the Investor Responsibility Research Center in Washington, the average shareholder vote for anti-poison-pill proposals at 19 companies this year rose to 38.7% from 29.4% in 32 contests in 1987. At Santa Fe Southern Pacific, 61% of shareholders voted in May to eliminate the company's poison pills. The resolution doesn't force the company to make the change, and so far it has not.

ROBERT MONKS, head of Institutional Shareholder Services, a pension fund consulting firm in Washington, D.C., and former administrator of Erisa, says, ''We use the proxy machinery reluctantly, to get management's attention. But we really look forward to a cooperative long-term arrangement between managers and owners.'' A fine thought, but practice to date belies it. Louis Lowenstein, a Columbia University corporate law professor, says the institutions are just looking at what affects current stock prices; of course, poison-pill-type resolutions generally knock prices down. ''All the activism is market-oriented,'' he says. ''Anything that upsets the stock price upsets fund managers. They are playing a short-term, speculative game.'' Robert Kirby, head of Capital Guardian Trust, a pension fund management group in Los Angeles, agrees: ''Every money manager's lucky day is when a raider launches an offer for his big holding. Most money managers will vote for anything that makes the stock go up tomorrow. We are criticized for making short-term decisions, but that's the situation we in the institutional investment business created for ourselves, because our results are measured monthly and quarterly.'' There's also a big question about how much managers of public funds and outside managers of private funds know about companies. In their campaign against corporate poison pills and other bylaws protecting management against takeovers, these institutional gadflies could use a little target practice. John Pound, an assistant professor at Harvard who has just completed a study on shareholder activism and corporate governance, analyzed more than 20 companies where there have been poison-pill recision resolutions. He found that the stocks of about half had soundly beaten the market. Says Pound: ''In my view, if you are going to target a few companies to get involved with, target those where management has performed poorly.''

Corporate officials question whether the motives of some of these attacks on poison pills and other anti-takeover bylaws have anything to do with the stock market or how a company is run. John Carroll, president of GTE Investment Management Corp., GTE's pension fund, says, ''The public funds have latched onto shareholder rights as a quasipolitical issue. Fund managers say, 'Shouldn't we have representatives for these faceless thousands of pensioners we all talk about?' There's a socialistic flavor to this.'' Gripes Andrew Sigler, chairman of Champion International: ''The guys who run the public funds are accountable to nobody. But ((doing battle with management)) is a marvelous way to get their names in the paper.'' WHAT HAPPENED in Wisconsin last year after General Motors' bout with Ross Perot illustrates the conflict public funds face. Enraged that shareholders had not been consulted when GM paid Perot $742 million in ''hushmail'' to remove himself from the company's board, the Wisconsin Investment Board filed a shareholder resolution ''condemning'' the use of greenmail at GM. The action shook up Chairman Roger Smith, who agreed to go to Madison and meet with the state board. The head of the investment board told Governor Tommy Thompson of Smith's impending visit. Thompson had just been elected on a campaign pledge of more jobs and a better business environment. Smith happened to be considering expanding a truck plant in Jamesville, Wisconsin. So the quiet meeting between Smith and the board over greenmail turned into a media extravaganza on the possible plant expansion, pushing the Perot matter well into the background. Sometimes the public employee funds stumble over their own conflicting goals. Even as Hanson is talking about a seat on Texaco's board, California has a law on the books requiring Calpers to divest itself by 1991 of all companies with operations in South Africa. Right now that would include Texaco. CEOs may derive some comfort from the fact that pension fund managers aren't likely to get organized enough to take full advantage of their power. There are some 870,000 pension funds, and the interests of their leadership varies. New York City's Goldin, for instance, voted for Icahn in the Texaco battle, while Regan and Hanson did not. To counteract the tendency of money managers to vote against them, CEOs have begun to apply a little muscle of their own. Last year, in response to the flurry of shareholder resolutions brought by members of the Council of Institutional Investors, the chairmen of such companies as GTE, Rockwell International, and International Paper launched a letter-writing campaign urging other CEOs to keep their own pension fund managers from voting against management. Recounts Capital Guardian's Kirby: ''A well-known CEO called to ask if I knew how we were going to vote on a particular issue. I said no. He said, 'Well, these are good people -- and by the way, did you know that our ^ 401(k) plan is managed by a fund you run?'' Kirby adds that calls like that are not uncommon. In June the Department of Labor started an investigation into undue influence by CEOs, who under the rules of Erisa are expressly forbidden from telling their pension managers, or the money managers to whom they have delegated the responsibility, how to vote. ''They think it's their money, and it's not,'' says Assistant Secretary of Labor David Walker. Coming up with enough evidence to prosecute may be almost impossible. Charles Lerner, the department's chief of enforcement, concedes, ''Things are done with a wink and a nod.'' There is an old Wall Street saying: Nothing recedes like excess. Some public and outside fund managers believe that institutional activism should move toward a less confrontational stage. Says Ned Regan: ''We should not be running around with our dukes up, yelling at Roger Smith about Perot. The question is how do we act as external proprietors'' -- that is, owners with influence but not with a daily voice in management. ''If we can define that role, then public pension power is not just appropriate but enormously healthy for the country.'' For starters, fund managers could review their holdings periodically, identify which companies are beginning to perform poorly, and apply some pressure on management to shape up. Teslik of the institutional investors' council suggests using managers of public funds as lobbyists. An example of such use might be to reinforce management's point of view when environmental, health care, drug approval, and product liability legislation is under consideration in Congress. ''We are one of the best assets a corporation can have in Washington,'' she says.''If I were a CEO, instead of battening down the hatches, I'd call us up. Use us.'' As long as corporate leaders are careful to stay within the law, they would do well to take her up on the offer.

BOX: ERISA: A WELL-INTENTIONED REFORM GONE WRONG

Shortly after Robert Monks agreed in 1984 to take over for one year as administrator of Erisa -- the Employee Retirement Income Security Act -- he called on his neighbor in the Watergate apartments, the late New York Senator Jacob Javits. Javits had fathered Erisa, a bill that was signed into law on Labor Day in 1974 to protect the pension and welfare benefits of workers. ''Tell me honestly,'' said Monks. ''Did you intend to create a single federal law that would govern the majority of stocks of all American corporations?'' Replied the wise old legislator: ''I've never been accused of modesty. But I have to admit, I never had that in mind at all.'' Economists are beginning to wonder just what Javits did have in mind. Erisa now sets the rules under which corporate pension funds operate. Companies are forking over some $30 billion each year in fees to a growing gaggle of service providers -- pension fund consultants, brokers, money managers, lawyers and actuaries -- who exist to help them comply with Erisa guidelines. Yet a couple of recent studies suggest that Erisa has done little to reduce risk or improve investment returns. Says Dennis Logue, co-author of the new book The Investment Performance of Corporate Pension Plans: ''It seems that, net-net, Erisa is a bad deal.'' The legislation grew out of trouble at Studebaker in 1963. When the auto producer closed its manufacturing operations, 4,000 workers lost some or all of their vested pension rights. To prevent a repeat and to minimize abuses such as looting, kickbacks, and inept management, Javits co-authored a reform bill. It imposed minimum standards of funding, vesting, and disclosure; outlined standards of fiduciary responsibility; and created the Pension Benefit Guaranty Corp., which collects premiums from corporations with pension funds and ensures that beneficiaries will get pensions, should the sponsoring company go out of business. Many in the pension business contend that the PBGC was what Javits and the major labor unions that lobbied for the act wanted most. Richard Ippolito, the PBGC's chief economist, says that fraud was not a significant problem before passage of Erisa, nor is it a problem now. The real impact of Erisa has been the transfer of several billion dollars from companies with well-funded pension plans to protect participants covered by underfunded plans -- primarily unionized workers in dying industries. The latest horror story is LTV Corp., which filed for bankruptcy in 1986. The PBGC took over the company's grossly underfunded pension plans, adding $2.3 billion to the PBGC's future obligations to pensioners. Companies now pay premiums to the PBGC of $16.50 to $50 per plan participant per year, depending on the adequacy of their plan's existing funding. Before the LTV debacle, the rate was a flat $8.50 per participant. Erisa may actually hurt pension funds. A study co-authored by Logue, a professor at Dartmouth's Amos Tuck school of business, concludes that Erisa has had no beneficial effect on the investment performance of corporate pension plans. Because the law says that fund managers must act in a ''prudent'' manner, they have rushed to hire a costly phalanx of actuaries, consultants, and lawyers to prove they have acted prudently. And companies have placed the investment decisions in the hands of professional money managers. They, in turn, use Erisa as an excuse to justify hyperactive trading: On average, 70% of the shares in fund portfolios are sold each year. Yet studies show that there is no correlation between high turnover and good performance. A study co-authored by Ippolito concludes that, due in part to high transaction costs, pension funds from 1978 to 1982 underperformed the stock and bond market indices by 0.5% per year. Monks, who now heads Institutional Shareholder Services, a pension fund consulting firm in Washington, D.C., argues that funds have no business being anything but long- term holders of securities and that CEOs should demand that their own funds' investment managers meet that obligation.

CHART: NOT AVAILABLE CREDIT: SOURCE: THE MONEY MARKET DIRECTORY CAPTION: Pension fund assets keep soaring. They're already nearing $1.8 trillion, and by the year 2000 are expected to reach $3.5 trillion. DESCRIPTION: Total assets from corporate pension funds, public pension funds, union pension funds.

CHART: NOT AVAILABLE CREDIT: SOURCE: U.S. DEPARTMENT OF LABOR CAPTION: THE NEW OWNERS Pension funds hold a growing share of corporate equity. Warns Erisa chief David Walker: ''You ignore 'em at your peril.'' DESCRIPTION: Percentage of pension fund assets in corporate equity.