Published: Monday, June 22, 2009 at 1:00 a.m. at the Sarasota Herald Tribune >

Every few years I gird my loins and prepare for the brickbats and outraged letters from financial advisers that will come as a result of writing a column on a controversial product that some sell, called an equity-indexed annuity, or EIA.

An EIA is not direct investments in stocks; it's a contract with an insurance company that's closer to a fixed-income security like a 10-year CD, but one that pays an unknown future interest rate. The interest rate is unknown because an EIA pays an interest rate that's the greater of a guaranteed minimum rate and one linked to the future performance of the stock market.

While these are complex products with many variations, it's illuminating to see how one version of the product works.

The minimum interest rate is 3 percent; however, it's only paid on 90 percent of the premium that the investor paid to purchase the contract. Further, the investor is only guaranteed that his total return will be at least that interest plus 90 percent of the premium paid.

Thus, a purchaser who paid a premium of $100,000 would after 10 years be guaranteed about $121,000. This is an effective compound annual interest rate of about 1.9 percent.

Of course, purchasers hope that the interest rate they actually receive will be higher than the guaranteed rate due to the performance of the stock market.

That annual interest rate is calculated by a formula linked to the annual change in the value of the S&P 500 index. Unfortunately, this index omits dividends. This is a significant omission as dividends over the recent past accounted for more than 20 percent of the total return of an investment in the S&P 500 itself.

Two of several other ways that the purchaser of an EIA loses some of the return of the S&P 500 is through participation rates and caps.

A participation rate reduces the amount of the return of the S&P 500 index with which the purchaser is credited. For example, 80 percent participation means in a year that the index returns 10 percent the interest-rate credited is only 8 percent.

A cap means in a year that the index does very well the purchaser does not receive credit in excess of the cap. For example, if the cap is 12 percent and the index return is 20 percent then the credit would only be 12 percent.

Both of these significantly penalize the purchaser of an EIA.

It's obvious how the participation rate hurts; however, it may be less obvious how the cap hurts. Consider that since 1996 there have been six years with index returns over 20 percent and two additional years with returns in the teens. A 12 percent cap for the period since 1996 could well have cut the total amount credited to the EIA by a third.

Additionally, EIA's have a "surrender fee." This means that if the purchaser wants to get out of the EIA before it matures in say, 10 years, he will have to forfeit perhaps 10 percent of the account value in the early years. This forfeited amount is typically reduced by 1 percent a year.

Given these return reducers, it's not surprising that one study shows that investors would about 99 percent of the time do better than one typical EIA with a portfolio of 60 percent in U.S. Treasury Securities and 40 percent in a mutual fund that tracks the S&P 500.

Another study looked at rolling 10-year periods since 1950. It showed that for all such periods the annualized returns for that portfolio would have been more than 3 percent, 80 percent of the time greater than 6 percent and 45 percent of the time greater than 10 percent.

In my view, EIA's are not for most people. They may be appropriate for those who are very risk-averse and who would normally invest in very long-term CDs. This is because they do offer the potential for higher returns than CDs through their link to the performance of the S&P 500.

Prospective purchasers of EIAs should be aware that commissions on these products are very high and that may cause a conflict of interest for their salesperson.