Mercer Management Journal28 The New Economics of Loyalty ProgramsThe dynamics of frequent flier and otherloyalty programs are changing on severalfronts. For airlines, the recent changes havecaused their strategic control over the pro-grams to be in danger of slipping into thehands of credit card companies that serve asintermediaries between airline and customer.As this market evolves, companies seekingto capture more value will have to deepentheir understanding of customer behaviorand refine how they segment customers. Foreach meaningful segment, companies willthen have to crisply define the currency oftheir loyalty program, so that customers givethem repeat business that’s profitable in thelong run.More Choice, Less LoyalThe original loyalty programs, pioneered byairlines in the 1980s, relied on air miles toreward customers. Reward miles became thede facto currency that customers earned bytraveling and burned by redeeming for freeair travel once they had accumulated certainthreshold mileage amounts. Hotels and carrental firms soon followed the airlines.Mileage rewards became the common cur-rency of the realm and promoted travel thatmany customers might otherwise not havebeen willing to buy. Airlines found value inseveral characteristics of the loyalty programs:They helped shape customers’ traveldecisions through the incentives of theair miles and rewards.As airlines distributed rewards, loyaltyprograms became an opaque channel fordistribution of their marginal capacity.Airlines and credit card intermediariesbenefited from the float of miles andbreakage economics (the difference incustomers’ collective rate of earning andburning the points).Credit card companies entered this marketas intermediaries on the earn side of the equa-tion, allowing frequent flyers to earn rewardpoints by using credit cards for purchases. Todo this, credit card companies bought milesfrom airlines and other enterprises for cash.Customers would then burn points to claimfree travel rewards from the airline.Today, revenues from credit card partnersconstitute the great majority of major air-lines’ total loyalty program revenues,according to analysis by Mercer ManagementFrequent flier and other loyalty programs are evolving rapidly, and airlinesare now vying with credit card companies for strategic control. To exploit thenew economics of loyalty programs, companies must balance the competingobjectives of driving repeat purchases and generating cash from partners.The key is to think of a program’s rewards as a currency and tailor that cur-rency for the most profitable customers.The New Economics of Loyalty ProgramsCustomers want options. How to address that priority andstill turn a profit?By Andrew Watterson, Scot Hornick, and Raj LalsareAndrew Watterson is a Dallas-based director, Scot Hornick is a Chicago-based director, and Raj Lalsareis a Dallas-based senior associate of Mercer Management Consulting. They can be reached email@example.com, firstname.lastname@example.org, and email@example.com.
Mercer Management JournalConsulting. The top three North Americanairlines—American, Delta, and United—eachderive close to $1 billion in revenues fromtheir loyalty programs, from more than 50million members each.The programs encourage customers to earnand burn mileage points in order to sustain acycle of repeat purchases. They also promoteuse of credit cards and other partner busi-ness, so that the airlines can sell more milesto their partners (Exhibit 1).In recent years, with more planes flyingclose to full, the availability and, possiblymore importantly, the perceived availability ofreward seats has declined. Among airlinesand a few other cases, the float or overhangof outstanding reward points has reachedexorbitant levels: Out of the roughly 2,000 bil-lion miles awarded, only about 500 billionhave been redeemed. As a result, customershave been turning to credit cards not only forearning miles but for burning them as well. Ina recent WebFlyer survey, 81% of respondentsagreed that “loyalty programs have gottenworse in rewarding loyal customers over thepast 25 years.”Not surprisingly, customers’ perceivedvalue of the currency is declining; in thesame WebFlyer survey, 93% of respondentsagreed that “loyalty programs are not servingloyal customers, but are primarily a mar-keting tool.”This attitude has a direct impact on howcredit card companies and their customersvalue a point. If customers put a lower valueon a certain reward currency, they have littleincentive to use the associated credit card toearn that currency. Customers have beendemanding more options, and credit cardcompanies are pressuring airlines to boost theperceived value of their points by providingmore options to burn mileage (Exhibit 2).American Express has reacted to the per-ceived decline in reward currency values. In arecent overhaul of its Membership Rewardsprogram, Amex is making two significantchanges: first, making it harder to earnpoints, especially “double points” foreveryday purchases at grocery stores and gasstations, in order to reduce customers’ earnvelocity; second, shifting customers’ earnoptions to new ones that are more attractiveto desirable customer segments, such asthose who earn points at the Gap and Targetversus those who earn at grocery stores andgas stations.Some programs have capitalized on thedemand for options. For instance, Hilton’sHHonors program offers redemption optionsincluding merchandise and tickets for air-lines, rail travel, theme parks, and cruises.Along the way, then, the two core objectivesof airline loyalty programs started to diverge.Providing more options clashes with the air-lines’ core goal of retaining customer loyalty.Consequently, despite the flow of paymentsfrom credit card companies to airlines, valuehas in fact been migrating to the credit cards.While credit cards already offer ways toearn points, they are responding to customerdemand for more burn options, particularlyfor those customers whose marginal utility ofreward points, beyond a threshold, is low.These include customers who cannot findtravel rewards they would consider mean-Perceived valueof loyaltyprograms tocustomers1990 Today• High load factors,perceived reducedseat availability• Rise of low-cost carriers• Illiquid rewardsCompetingprogramsAirline frequentflyer programsAirline frequentflyer programsCompetingprograms• Addition of partners,including credit cards• Reward options ofairline travel,hotel, car rental,merchandiseExhibit 1 The loyalty space has changedThe New Economics of Loyalty Programs 29
Mercer Management Journal30 The New Economics of Loyalty Programsingful; those who would rather pay for theirtravel rather than deal with the hassles ofaward redemption; and those who haveearned more points than they can ever use.Hence the tag line for the American ExpressMembership Rewards program: “Because noteveryone lives to earn airline miles.” The pro-gram lured customers who did not wanttravel rewards, offering to redeem earnedmiles for other rewards. By expanding theirintermediation, the credit card firms arediluting the travel loyalty programs’ influenceover travel purchase decisions.Capital One has made perhaps the mostaggressive push into the airline loyalty spacewith its “No Hassle Miles” cards. Customerstrade 15,000 miles for flights worth up to$150, 35,000 miles for $151-$350 flights, andso on. Why would this be attractive to somecustomers? Airlines may or may not be ableto fulfill an award trip to Hawaii, dependingon seat availability. But with the credit cards,by contrast, there is no guessing, becausecredit cards buy the ticket outright. In returnfor removing this uncertainty, customers paya transaction fee.Coin of the RealmIt’s helpful for executives to think of theloyalty market as a form of currency market.Airlines, hotels, credit cards, and other pro-gram owners all have their currenciesfloating in consumers’ wallets.Some currencies are turning out to bestronger than others. Starwood, the hotel andresort chain, has engineered a higher-valuecurrency than have airlines or other hotels.Customers realize that their implied returnsvary across loyalty programs, and they areincreasingly choosing one currency overanother (Exhibit 3).In real monetary markets, there have beenperiods when one reserve currency losesfavor and the world shifts to another reservecurrency. During the era of the gold standard,the British pound was the dominant cur-rency. After 1914, as Great Britain turned frombeing a net creditor to a net debtor, the U.S.dollar gained primacy. With perpetual currentaccount and fiscal deficits, the pound neverregained its strength, and the dollar hasremained unchallenged as the worlds mainreserve currency. According to The Economist,nearly 70% of official foreign exchangereserves are in dollars today, with the Eurobeing the second most commonly tradedreserve currency.For loyalty programs, competitors must askthemselves which currency will gain pri-macy—credit card currency, airline currency,hotel currency, or something else?Airline loyalty program currencies clearlyExhibit 2 Customer preferences have evolvedlowBurn velocityhighhighEarnvelocitylow“How fast can Iget to the elitestatus? ”“How much forthe free trip toHawaii?”Customerpriority: elite status,all upgrades,all the timefewBurn optionsmanymanyEarnoptionsfew“Can I earnpoints buyinga car? ”“Can I usepoints to buya stereo?”Customerpriority: ?From the traditional supply and demand side ofloyalty economics......Customers are now seeking more options
Mercer Management Journalhave suffered the most over the past fewyears, as customers perceive that less aircraftcapacity is earmarked for rewards, loweringthe implicit value of airline miles. In aWebFlyer survey, customers reported a 50%success rate with airline award availability,compared to a reported success rate of 75%with hotel awards. As the overhang of rewardpoints increases, the marginal value of pointsto customers will decline further, leading todecreased influence on future purchase andredemption decisions. With credit card com-panies increasing more earn and burnoptions, customers are learning to bypass thetraditional airline loyalty program, putting theviability of this traditional model in question.The risk of erosion of customer loyalty,therefore, is real for airlines, and loyalty pro-grams must be restructured to acknowledgethis new reality. Those programs that do notchange face the risk of being secondary cur-rencies, with a downward spiral of their cur-rency and customer loyalty. Those that dorestructure raise their odds of owning a dom-inant currency that customers want to keepand trade—leading to a mutually reinforcingspiral of increasing currency value and strongcustomer loyalty.Several scenarios are possible:Realizing that credit cards are offering amore tradable reward currency, customersstampede out of airline programs. Giventhe slow pace of change in loyalty pro-grams (there haven’t been any major over-hauls of loyalty programs in nearly adecade), this scenario seems unlikely, sincecustomers keep demanding air miles.A more likely scenario is the continuedgradual erosion of airline loyalty pro-grams, with credit cards seizing strategiccontrol and airlines experiencing dilutedmonetary value and eroded loyalty.Loyalty programs must realize the nextwave of change will be driven by finan-cially flush credit card providers, such asCapital One, trying to disrupt the directbond between loyalty programs and cus-tomers. It all depends on how quickly andaggressively the credit card providers areable to capture value.Some airlines arise to confront the chal-lenge. United’s recent launch of the“Choices” currency, which allows cus-tomers to redeem miles for non-travelawards, looks like such an attempt.Customer who carry United’s co-brandedcredit card from Chase can earn a parallelcurrency to United’s travel miles, thusincreasing the perceived value of the cur-Exhibit 3 Customers realize their implicit returns vary across loyalty programs0.00.51.01.52.02.53.03.54.00 2 4 6 8Earn velocity (points/$)HHonorsStarwoodPointvalue (¢)1% return2% return3% returnAmexMembershipRewardsDinersMarriottDiscoverHertzCompetitive valuation of some reward currenciesAirline programs havelittle differentiation“Return” in this contextindicates customers’implicit ROI for everydollar spent on theoriginal purchaseNote: Earn velocity assumes $5,000 annual direct spend and $10,000 annual credit card spend; point value shownfor burning directly into company product or for highest-returning rewardSource: Company websites; Mercer analysisThe New Economics of Loyalty Programs 31
Mercer Management Journal32 The New Economics of Loyalty Programsrency for those customers who value non-travel rewards. This approach could keepthe credit card partners happy as well.For airlines, it would be a false hope todepend on customers’ existing balance ofreward points as equity in loyalty programs.Customers can change behavior quickly,especially when they perceive their marginalutility of reward points to be declining.Airlines must act before the credit card part-ners either decline to renew or substantiallyrestructure the contracts that generate somuch revenue for the loyalty programs.In addressing this multi-dimensional chal-lenge, where should managers of loyalty pro-grams start their analysis: Customersatisfaction with the program? Customers’intent to re-purchase? Customer value?Credit card partners’ satisfaction? Parent air-lines’ willingness to provide capacity?Our experience suggests that to capturevalue in this market with its new economics,airline executives should redesign their loy-alty business by addressing four funda-mental questions (Exhibit 4).Which customers is the loyalty program tar-geting? Different customer segments haveExhibit 4 Levers to redesign the loyaltybusiness modelA fundamental questioning of the model required tosustain customer loyalty and revenuesWhichcustomers?Whichpartners?Which earn-and-burn structures?What relationshipwith the parentcompany?• Current and future segments• Segment needs and value potential• Number of partners• Breadth/depth of offerings• Earn and burn velocity and options• Transferability to other rewardcurrencies• Exchange rates• Brand identity• Financial relationship with parententerprise• Valuation and financial structureof the loyalty programdifferent marginal utility of a currency anddifferent reward preferences. Do you have theright currency for the right customers?One useful approach in this regard is toestablish two currencies for different seg-ments: a primary currency to meet the needsof loyal customers and a secondary currencyfor those who seek other rewards. It is pos-sible to identify several meaningful customersegments and respond to their needs withseveral reward currencies. However, imple-menting more than one currency will requireinvestment in the program infrastructure andcapabilities, as most loyalty programs today,especially the airline versions, are operatingwith aging systems. Moreover, the approachto customer selection must be tailored to theunique characteristics of the loyalty programand underlying service brand (Exhibit 5).Which partners should the program keep?Because customers are showing a healthyappetite for more reward options, loyalty pro-grams need trading partners to helpstrengthen the brand and currency. Of course,customers’ preferences for a given partner-ship and perceptions of a given brand have tobe considered in establishing partnerships.In a recent Mercer survey, a large customersegment, which had high spending on gro-ceries, displayed three times as strong a pref-erence for earning airline miles via groceryshopping and gas stations as via wirelessservice. Other segments with different demo-graphics would have other preferences. Yetloyalty programs are not currently differenti-ating among segments or developing partner-ships accordingly. Many airline loyaltyprograms, for example, continue to bombardfrequent flyers with wireless service promo-tions, when many of those travelers may havelittle desire for them.In the same survey, customers indicatedtheir preference will increase if events andexperiential rewards were added to airlinerewards—and their preference would increasefour times as much if merchandise wereadded to the reward list.Here, loyalty programs face a risk. A partner-
Mercer Management JournalExhibit 5 Customer preferences vary by activity frequencyKey driver of loyaltyHighfrequencyBaseRecognition andcurrency valueCustomer segmentExpand loyaltyfootprint• Broader recognition• Partner burn options• Enhance value of air award• Joint targeted promotionsAirline award andserviceAccelerate to airlineaward• Family redemption• Cash + points• One-way redemption• Improve service efficiencyProgram evolution Potential enhancementsship with a casino, wherein spending moneyat the casino can earn reward points, may notbe acceptable to all customers. Some mightprefer a partnership with a steak house, otherswith an electronics retailer. The key is to offerthe right selection of partners or “trading mer-chants” to the corresponding customers sothey can use their currency as they prefer.Which earn and burn structures should beoffered? This involves determining, first, howa reward point will be valued by customers,since this will determine how much partnersare willing to pay for points. Next, determineat what exchange rates customers will beable to trade the currency with other rewardcurrencies.For example, in United’s Choices pro-grams, 15,000 Choices can be redeemed for a$120 hotel stay—an implied exchange rate of125 Choices per dollar. Hilton HHonors pro-gram lets customers redeem 55,000 pointsfor a 3-day pass at Disneyland worth about$100, an implied exchange rate of 550 pointsper dollar.What relationship with the parent company isoptimal? Traditionally, loyalty programs havebeen owned by the parent enterprise, but thisis changing. For the next generation of pro-grams, executives must determine if theywant to retain full ownership of their cur-rency, or to float it freely. Both options havemerits and drawbacks. Owning a currencyimplies backing it up with reserves, that is,the capacity (and contingent liability) to pro-vide rewards. However, ownership also pro-vides greater control over the selection oftrading partners and exchange rates.On the other hand, by spinning off the loyaltyprogram, enterprises can unlock substantialmonetary value. Last year, Air Canada raised$200 million by selling 12.5% of its loyaltyscheme, Aeroplan. This implied a total valua-tion of $1.6 billion for Aeroplan.The prospect ofunlocking value from the loyalty program hasto be balanced with the risk of the programbeing too independent to drive repeat purchasebehavior to the airline enterprise.* * *Customer loyalty programs have becomea market with many currencies, each withdifferent perceived values and impliedexchange rates. The currency of credit cardsis rising, as credit card firms appear to beseizing strategic control by capitalizing oncustomer demand for more options and thedeclining perceived value of loyalty points.In this new environment, loyalty programsmust balance the competing objectives ofdriving repeat purchase behavior and gener-ating cash value from partners. Some pro-gram restructuring is in order, starting withcrisply defining the program’s currency. Whatcustomers care about is no longer just milesor points. They want options, and successfulprograms will address that priority straighton, while ensuring that any new offeringsalso create superior business economics.The New Economics of Loyalty Programs 33