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BirdsEye View

customer loyalty programs...

Check out the new entry in the Bird Dropping section of www.anatbird.com, Wing Tips. It includes travel tips generated during my years of travel, both domestic and international. I look forward to some of getting additional ideas from you that I'll share with the readers and also enjoy myself on future trips.

Have a profitable week,

Customer Loyalty Programs And Their Effect On Customer Retention And Profitability Lessons From The Airline Industry

How many times did you take a less-then-perfectly-convenient flight, or make an extra stop, just to fly on the airline where you accumulate your frequent flyer points? This is a typical behavior among flyers, and it proves an important point: the airlines have figured out the key to lock in customers and change their behavior and aggregate their purchases with one primary vendor.

This type of behavior is what banks are seeking. Our code words for it is "relationship banking" or "share of wallet", but what we really mean is: we want the customer to self-select our bank whenever they consider purchasing a financial product, even if what we have to offer isn't EXACTLY what the customer wants. We would love our customers to think of us first in any buying situation where our product line might fit. The airline industry has managed to achieve this effect. Is it all it's cracked out to be? Let's consider.

Before you say, "well, banks aren't airlines", let's review the parallels between these two industries:

  1. Deregulation brought about unlikely competitors. Both industries have been deregulated in the past thirty years, which resulted in two phenomena :

    • Unlikely competitors. The airlines found themselves competing with music distribution companies (Virgin) and entertainment vendors (Hooters), Banks are competing with mega-retailers (Wal-Mart) and other non-depository financial institutions (ING)

    • New business models. The airlines discovered that the hub-and-spoke model isn't the only one that works. In fact, others, such as Southwest and Jet Blue, offered breakthrough models successfully. Similarly, purely internet banks (ING again) and Burger King-like branches with minimal lending activities (Commerce) proved that untraditional banking can be profitable and grow.

  2. Price constrains lead to technological solutions. The airlines created SABER and other major reservations systems, started offering online reservations, then moved to charge for reservations by phone, in person or by paper (does this remind you of the $3 that shook Chicago when First Chicago charged customers for using tellers?) and managed to migrate the bulk of its customers most effectively to electronic check-in both online and at the airport. Banks haven't gone quite that far yet, but internet banking, differentiated CD rates online vs. in the branch, ATM machines displacing tellers as a source of cash and ACH outstripping the growing and total volume of paper checks are but a few examples of the application of technology toward cost efficiencies in banking.

  3. The best customers aren't the most frequent ones. While this is true for both industries, many banks haven't discovered this yet. In fact, most branch managers and lenders know who their most frequent customers are, and believe they are also the most profitable. In fact, they are not, and often they destroy value rather than build it for shareholders. This is a crucial fact, since loyalty programs in both industries (in their infancy in banking to be sure) reward frequency and not value (more on this point later).

The airlines have built their loyalty programs about 25 years ago, and they have been extremely successful in causing customers to behave in a way that will maximize the rewards they coveted most. The programs remained largely unchanged for years, until September 11 compelled the industry to take a fresh look at Return on the Investment, given the huge and negative financial ramifications of that catastrophic event.

Until then, say, during the ‘80s, the mega airlines could starve out poor competitors by controlling rates and gates. They couldn't do that in the 21st century, when discounters own at least 20% market share in the US. More importantly, low cost airlines are present in 70-80% of the routes in the US, thereby significantly impacting, if not dictating, pricing. If you live in Philadelphia, you witnessed this first hand in recent years when Southwest entered the market and the entire pricing structure was destroyed (to customers' rejoice).

At the time, major airlines discovered that their business model is broken. They depended on high yield pricing, which the low cost carriers eroded. They couldn't get away with such pricing anymore since customers started defecting to the discounters. Mid-to-low yield traffic moved to the discount airlines, while high yield customer expectations could no longer be met in traditional ways. The major airlines had to change their business model or they were doomed for extinction.

Consider the following changes (and their parallels in banking):

THEN v. NOW
THEN NOW
1 million members 40 million
Average fare $182 $102 (and falling...)
Passenger yield 13.8 C >10 cents
Capacity 45 billion
Available seat miles
>150 billion
Premium cabin
Widely available
Premium cabin
shrinking

Airlines witnessed these changes without taking dramatic action to ensure that they target their "sweet spot" customer more carefully and develop a product line that appeals specifically to that segment's requirements. They ceded the market to various players, from the discounters to the high end players (such as Midwest Express) without a focused strategy to attract and retain at least one major segment. Take a look at the three customers below:

  Customer 1 Customer 2 Customer 3
Status Platinum Platinum 1 million miler Gold
2005 Segments 53 121 75
2005 base miles 227K 88K 60K
Fares Purchased Business/Full fare Deep discount coach Mid-priced coach
Lifetime miles 556K 1,512K 98K
2005 revenue $84K $11K $18K
Avg. per segment $837 $92 $244

The first customer is most profitable even though they don't fly the most miles. The second customer, the heaviest flyer, takes discount fares and flies short hops in markets with at least two discount carriers. The third customer is break-even.

The chart above depicts the striking difference between volume and value, something which both airlines and banks often miss. We give CD customers discounts for large deposits, yet it reduces their profitability from breakeven to a loss. We waive a frequent NSF customer fees because of their volume, and eliminate their value. Airlines do the same, by rewarding high volume, high segment customers. These might be the most costly customers, who are encouraged to take as many segments as possible, thereby creating additional costs for multiple boarding passes, numerous baggage transfers etc., while the most profitable customers remain unrewarded since the criteria set for the loyalty program until recently did not recognize profitability/value, only volume.

Both banks and airlines can learn from this error by redesigning their rewards systems to give the highest rewards to those who create the most value, as well as encourage the right behaviors by those customers.

Examples of such changes include:

  • Revise mile credits to incorporate profitability. For example, give a highly discounted flown mile only ½ a mile credit vs. a full first class seat at, say 2 times the miles flown

  • Encourage other profitable behaviors. For example, offer appropriately priced upgrade certificates; simplify upgrade process while slowing down earn velocity

  • Build longer-term affinity by offering mass-customized rewards including individualized choices such as miles carry-over privileges; mile gifting and status gifting; companion upgrades, etc.

  • Redesign aircraft cabins to increase profitability. For example, some airlines reduced first class capacity by 20-30%, thereby creating more coach rooms but also disenchanting higher-end customers.

One more technique that worked for some airlines is leading the pack. As in banking, service and loyalty program changes cannot be patented. However, plans typically aren't changed mid-year. Thus, an airline that put together an innovative loyalty program has one year lead over the others.

Many airlines found it technologically challenging to look at customers' profitability vs. frequency of use. Banks face the same challenge, which is compounded by the fact that their profitability measurement tools are much less precise than the airlines.

In addition, airlines had to mount a huge customer education campaign to migrate customers to the right channels and teach them what behaviors will yield the best results for them and the airlines as well. A simple example is, airlines typically give a customer that made reservations and purchased a ticket online 1000 free miles into their loyalty program account. Conversely, customers have to pay for all other channels of ticket purchases, and some are outright annoyingly difficult (have you tried that voice recognition technology by contacting airlines by phone lately? Did you notice Southwest doesn't have that impediment?).

Last, front line education has not been easy either, resulting in some confusion among airline employees as programs changed and certain plans have become more complex.

There is a myriad of lessons to be parlayed into the banking context in the airlines' experience with loyalty programs. Since most banks are in their infancy when it comes to such programs, there is much that can be integrated into program structuring early on.

  • Do not confuse value with volume

  • Avoid one size fits all programs both in terms of rewards as well as what it takes to achieve them (like incentive compensation, it works better when there is more than a single level of achievement and a single reward offer)

  • Don't under-estimate the consumer's ability to integrate technology when properly educated. Just observe the electronic check-in counters that are popping in every airport and how many people utilize them

  • Integrate rewards and "taxes" to encourage desired behavior