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The New Economics of Loyalty Programs
Customers want options. How to address that priority and
still turn a profit?
By Andrew Watterson, Scot Hornick, and Raj Lalsare
Frequent flier and other loyalty programs are evolving rapidly, and airlines
are now vying with credit card companies for strategic control. To exploit the
new economics of loyalty programs, companies must balance the competing
objectives 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.
T he dynamics of frequent flier and other
loyalty programs are changing on several
fronts. For airlines, the recent changes have
been willing to buy. Airlines found value in
several characteristics of the loyalty programs:
caused their strategic control over the pro- They helped shape customers’ travel
grams to be in danger of slipping into the decisions through the incentives of the
hands of credit card companies that serve as air miles and rewards.
intermediaries between airline and customer.
As this market evolves, companies seeking As airlines distributed rewards, loyalty
to capture more value will have to deepen programs became an opaque channel for
their understanding of customer behavior distribution of their marginal capacity.
and refine how they segment customers. For
each meaningful segment, companies will Airlines and credit card intermediaries
then have to crisply define the currency of benefited from the float of miles and
their loyalty program, so that customers give breakage economics (the difference in
them repeat business that’s profitable in the customers’ collective rate of earning and
long run. burning the points).
More Choice, Less Loyal Credit card companies entered this market
The original loyalty programs, pioneered by as intermediaries on the earn side of the equa-
airlines in the 1980s, relied on air miles to tion, allowing frequent flyers to earn reward
reward customers. Reward miles became the points by using credit cards for purchases. To
de facto currency that customers earned by do this, credit card companies bought miles
traveling and burned by redeeming for free from airlines and other enterprises for cash.
air travel once they had accumulated certain Customers would then burn points to claim
threshold mileage amounts. Hotels and car free travel rewards from the airline.
rental firms soon followed the airlines. Today, revenues from credit card partners
Mileage rewards became the common cur- constitute the great majority of major air-
rency of the realm and promoted travel that lines’ total loyalty program revenues,
many customers might otherwise not have according to analysis by Mercer Management
Andrew Watterson is a Dallas-based director, Scot Hornick is a Chicago-based director, and Raj Lalsare
is a Dallas-based senior associate of Mercer Management Consulting. They can be reached at
email@example.com, firstname.lastname@example.org, and email@example.com.
28 The New Economics of Loyalty Programs Mercer Management Journal
Exhibit 1 The loyalty space has changed Not surprisingly, customers’ perceived
value of the currency is declining; in the
same WebFlyer survey, 93% of respondents
• High load factors, agreed that “loyalty programs are not serving
perceived reduced loyal customers, but are primarily a mar-
• Rise of low-cost carriers
• Illiquid rewards This attitude has a direct impact on how
flyer programs credit card companies and their customers
value a point. If customers put a lower value
on a certain reward currency, they have little
incentive to use the associated credit card to
earn that currency. Customers have been
Airline frequent demanding more options, and credit card
companies are pressuring airlines to boost the
perceived value of their points by providing
Competing more options to burn mileage (Exhibit 2).
• Addition of partners,
programs American Express has reacted to the per-
including credit cards
• Reward options of ceived decline in reward currency values. In a
hotel, car rental,
recent overhaul of its Membership Rewards
merchandise program, Amex is making two significant
changes: first, making it harder to earn
1990 Today points, especially “double points” for
everyday purchases at grocery stores and gas
Consulting. The top three North American stations, in order to reduce customers’ earn
airlines—American, Delta, and United—each velocity; second, shifting customers’ earn
derive close to $1 billion in revenues from options to new ones that are more attractive
their loyalty programs, from more than 50 to desirable customer segments, such as
million members each. those who earn points at the Gap and Target
The programs encourage customers to earn versus those who earn at grocery stores and
and burn mileage points in order to sustain a gas stations.
cycle of repeat purchases. They also promote Some programs have capitalized on the
use of credit cards and other partner busi- demand for options. For instance, Hilton’s
ness, so that the airlines can sell more miles HHonors program offers redemption options
to their partners (Exhibit 1). including merchandise and tickets for air-
In recent years, with more planes flying lines, rail travel, theme parks, and cruises.
close to full, the availability and, possibly Along the way, then, the two core objectives
more importantly, the perceived availability of of airline loyalty programs started to diverge.
reward seats has declined. Among airlines Providing more options clashes with the air-
and a few other cases, the float or overhang lines’ core goal of retaining customer loyalty.
of outstanding reward points has reached Consequently, despite the flow of payments
exorbitant levels: Out of the roughly 2,000 bil- from credit card companies to airlines, value
lion miles awarded, only about 500 billion has in fact been migrating to the credit cards.
have been redeemed. As a result, customers While credit cards already offer ways to
have been turning to credit cards not only for earn points, they are responding to customer
earning miles but for burning them as well. In demand for more burn options, particularly
a recent WebFlyer survey, 81% of respondents for those customers whose marginal utility of
agreed that “loyalty programs have gotten reward points, beyond a threshold, is low.
worse in rewarding loyal customers over the These include customers who cannot find
past 25 years.” travel rewards they would consider mean-
Mercer Management Journal The New Economics of Loyalty Programs 29
Exhibit 2 Customer preferences have evolved
From the traditional supply and demand side of ...Customers are now seeking more options
priority: elite status, Customer
all upgrades, priority: ?
“How fast can I all the time “Can I earn
get to the elite points buying
high status? ” many a car? ”
“How much for “Can I use
the free trip to points to buy
low few a stereo? ”
low high few many
Burn velocity Burn options
ingful; those who would rather pay for their gram owners all have their currencies
travel rather than deal with the hassles of floating in consumers’ wallets.
award redemption; and those who have Some currencies are turning out to be
earned more points than they can ever use. stronger than others. Starwood, the hotel and
Hence the tag line for the American Express resort chain, has engineered a higher-value
Membership Rewards program: “Because not currency than have airlines or other hotels.
everyone lives to earn airline miles.” The pro- Customers realize that their implied returns
gram lured customers who did not want vary across loyalty programs, and they are
travel rewards, offering to redeem earned increasingly choosing one currency over
miles for other rewards. By expanding their another (Exhibit 3).
intermediation, the credit card firms are In real monetary markets, there have been
diluting the travel loyalty programs’ influence periods when one reserve currency loses
over travel purchase decisions. favor and the world shifts to another reserve
Capital One has made perhaps the most currency. During the era of the gold standard,
aggressive push into the airline loyalty space the British pound was the dominant cur-
with its “No Hassle Miles” cards. Customers rency. After 1914, as Great Britain turned from
trade 15,000 miles for flights worth up to being a net creditor to a net debtor, the U.S.
$150, 35,000 miles for $151-$350 flights, and dollar gained primacy. With perpetual current
so on. Why would this be attractive to some account and fiscal deficits, the pound never
customers? Airlines may or may not be able regained its strength, and the dollar has
to fulfill an award trip to Hawaii, depending remained unchallenged as the world's main
on seat availability. But with the credit cards, reserve currency. According to The Economist,
by contrast, there is no guessing, because nearly 70% of official foreign exchange
credit cards buy the ticket outright. In return reserves are in dollars today, with the Euro
for removing this uncertainty, customers pay being the second most commonly traded
a transaction fee. reserve currency.
For loyalty programs, competitors must ask
Coin of the Realm themselves which currency will gain pri-
It’s helpful for executives to think of the macy—credit card currency, airline currency,
loyalty market as a form of currency market. hotel currency, or something else?
Airlines, hotels, credit cards, and other pro- Airline loyalty program currencies clearly
30 The New Economics of Loyalty Programs Mercer Management Journal
Exhibit 3 Customers realize their implicit returns vary across loyalty programs
Competitive valuation of some reward currencies
Starwood “Return” in this context
3.0 indicates customers’
Airline programs have
implicit ROI for every
2.5 little differentiation
dollar spent on the
value (¢) Amex
0.5 3% return
Diners 2% return
0 2 4 6 8
Earn velocity (points/$)
Note: Earn velocity assumes $5,000 annual direct spend and $10,000 annual credit card spend; point value shown
for burning directly into company product or for highest-returning reward
Source: Company websites; Mercer analysis
have suffered the most over the past few more tradable reward currency, customers
years, as customers perceive that less aircraft stampede out of airline programs. Given
capacity is earmarked for rewards, lowering the slow pace of change in loyalty pro-
the implicit value of airline miles. In a grams (there haven’t been any major over-
WebFlyer survey, customers reported a 50% hauls of loyalty programs in nearly a
success rate with airline award availability, decade), this scenario seems unlikely, since
compared to a reported success rate of 75% customers keep demanding air miles.
with hotel awards. As the overhang of reward
points increases, the marginal value of points A more likely scenario is the continued
to customers will decline further, leading to gradual erosion of airline loyalty pro-
decreased influence on future purchase and grams, with credit cards seizing strategic
redemption decisions. With credit card com- control and airlines experiencing diluted
panies increasing more earn and burn monetary value and eroded loyalty.
options, customers are learning to bypass the Loyalty programs must realize the next
traditional airline loyalty program, putting the wave of change will be driven by finan-
viability of this traditional model in question. cially flush credit card providers, such as
The risk of erosion of customer loyalty, Capital One, trying to disrupt the direct
therefore, is real for airlines, and loyalty pro- bond between loyalty programs and cus-
grams must be restructured to acknowledge tomers. It all depends on how quickly and
this new reality. Those programs that do not aggressively the credit card providers are
change face the risk of being secondary cur- able to capture value.
rencies, with a downward spiral of their cur-
rency and customer loyalty. Those that do Some airlines arise to confront the chal-
restructure raise their odds of owning a dom- lenge. United’s recent launch of the
inant currency that customers want to keep “Choices” currency, which allows cus-
and trade—leading to a mutually reinforcing tomers to redeem miles for non-travel
spiral of increasing currency value and strong awards, looks like such an attempt.
customer loyalty. Customer who carry United’s co-branded
Several scenarios are possible: credit card from Chase can earn a parallel
currency to United’s travel miles, thus
Realizing that credit cards are offering a increasing the perceived value of the cur-
Mercer Management Journal The New Economics of Loyalty Programs 31
rency for those customers who value non- different marginal utility of a currency and
travel rewards. This approach could keep different reward preferences. Do you have the
the credit card partners happy as well. right currency for the right customers?
One useful approach in this regard is to
For airlines, it would be a false hope to establish two currencies for different seg-
depend on customers’ existing balance of ments: a primary currency to meet the needs
reward points as equity in loyalty programs. of loyal customers and a secondary currency
Customers can change behavior quickly, for those who seek other rewards. It is pos-
especially when they perceive their marginal sible to identify several meaningful customer
utility of reward points to be declining. segments and respond to their needs with
Airlines must act before the credit card part- several reward currencies. However, imple-
ners either decline to renew or substantially menting more than one currency will require
restructure the contracts that generate so investment in the program infrastructure and
much revenue for the loyalty programs. capabilities, as most loyalty programs today,
In addressing this multi-dimensional chal- especially the airline versions, are operating
lenge, where should managers of loyalty pro- with aging systems. Moreover, the approach
grams start their analysis: Customer to customer selection must be tailored to the
satisfaction with the program? Customers’ unique characteristics of the loyalty program
intent to re-purchase? Customer value? and underlying service brand (Exhibit 5).
Credit card partners’ satisfaction? Parent air-
lines’ willingness to provide capacity? Which partners should the program keep?
Our experience suggests that to capture Because customers are showing a healthy
value in this market with its new economics, appetite for more reward options, loyalty pro-
airline executives should redesign their loy- grams need trading partners to help
alty business by addressing four funda- strengthen the brand and currency. Of course,
mental questions (Exhibit 4). customers’ preferences for a given partner-
ship and perceptions of a given brand have to
Which customers is the loyalty program tar- be considered in establishing partnerships.
geting? Different customer segments have In a recent Mercer survey, a large customer
segment, which had high spending on gro-
Exhibit 4 Levers to redesign the loyalty ceries, displayed three times as strong a pref-
business model erence for earning airline miles via grocery
A fundamental questioning of the model required to shopping and gas stations as via wireless
sustain customer loyalty and revenues
service. Other segments with different demo-
graphics would have other preferences. Yet
Which • Current and future segments loyalty programs are not currently differenti-
customers? • Segment needs and value potential ating among segments or developing partner-
ships accordingly. Many airline loyalty
• Number of partners programs, for example, continue to bombard
partners? • Breadth/depth of offerings frequent flyers with wireless service promo-
tions, when many of those travelers may have
• Earn and burn velocity and options
little desire for them.
Which earn-and- • Transferability to other reward
burn structures? currencies
In the same survey, customers indicated
their preference will increase if events and
• Exchange rates
experiential rewards were added to airline
• Brand identity
rewards—and their preference would increase
What relationship • Financial relationship with parent
with the parent enterprise four times as much if merchandise were
company? added to the reward list.
• Valuation and financial structure
of the loyalty program Here, loyalty programs face a risk. A partner-
32 The New Economics of Loyalty Programs Mercer Management Journal
Exhibit 5 Customer preferences vary by activity frequency
Customer segment Key driver of loyalty Program evolution Potential enhancements
• Broader recognition
Recognition and Expand loyalty • Partner burn options
High currency value footprint • Enhance value of air award
frequency • Joint targeted promotions
• Family redemption
• Cash + points
Base Airline award and Accelerate to airline
• One-way redemption
• Improve service efficiency
ship with a casino, wherein spending money the capacity (and contingent liability) to pro-
at the casino can earn reward points, may not vide rewards. However, ownership also pro-
be acceptable to all customers. Some might vides greater control over the selection of
prefer a partnership with a steak house, others trading partners and exchange rates.
with an electronics retailer. The key is to offer On the other hand, by spinning off the loyalty
the right selection of partners or “trading mer- program, enterprises can unlock substantial
chants” to the corresponding customers so monetary value. Last year, Air Canada raised
they can use their currency as they prefer. $200 million by selling 12.5% of its loyalty
scheme, Aeroplan. This implied a total valua-
Which earn and burn structures should be tion of $1.6 billion for Aeroplan. The prospect of
offered? This involves determining, first, how unlocking value from the loyalty program has
a reward point will be valued by customers, to be balanced with the risk of the program
since this will determine how much partners being too independent to drive repeat purchase
are willing to pay for points. Next, determine behavior to the airline enterprise.
at what exchange rates customers will be
able to trade the currency with other reward ***
currencies. Customer loyalty programs have become
For example, in United’s Choices pro- a market with many currencies, each with
grams, 15,000 Choices can be redeemed for a different perceived values and implied
$120 hotel stay—an implied exchange rate of exchange rates. The currency of credit cards
125 Choices per dollar. Hilton HHonors pro- is rising, as credit card firms appear to be
gram lets customers redeem 55,000 points seizing strategic control by capitalizing on
for a 3-day pass at Disneyland worth about customer demand for more options and the
$100, an implied exchange rate of 550 points declining perceived value of loyalty points.
per dollar. In this new environment, loyalty programs
must balance the competing objectives of
What relationship with the parent company is driving repeat purchase behavior and gener-
optimal? Traditionally, loyalty programs have ating cash value from partners. Some pro-
been owned by the parent enterprise, but this gram restructuring is in order, starting with
is changing. For the next generation of pro- crisply defining the program’s currency. What
grams, executives must determine if they customers care about is no longer just miles
want to retain full ownership of their cur- or points. They want options, and successful
rency, or to float it freely. Both options have programs will address that priority straight
merits and drawbacks. Owning a currency on, while ensuring that any new offerings
implies backing it up with reserves, that is, also create superior business economics.
Mercer Management Journal The New Economics of Loyalty Programs 33