Are all "points as good as cash" loyalty programs inevitably doomed?
Feb 15, 2015, 5:21 pm
#1
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Are all "points as good as cash" loyalty programs inevitably doomed?
I have been trying to understand what Southwest Airlines just did to its program and why. I believe that accounting rules, and to some extent reality itself, create sufficient incentives to destroy any "points as good as cash" revenue-based redemption program.
If miles and points were recorded at the time of issuance as a liability at their redemption value, airlines would have little incentive to "print" their currencies without limit. An overly generous frequent flyer program would be seen immediately as a loss-creating enterprise. But the accounting treatment does not work that way. Overly generous programs are common, with accounting rules concealing the losses for several years until reality creeps in and forces the airline to devalue its miles or points.
Let's look at the incentives created by the accounting rules. Most airlines account for miles or points in two buckets. The first bucket is points earned by flying. The second bucket is points sold to third parties, primarily banks.
Under IAS 18 Paragraph 19, points in the first bucket are NOT carried as a liability, except to the extent that an airline will incur small marginal costs to carry a passenger in an otherwise empty seat. You could look at this accounting treatment from one perspective as saying that a points redemption will NEVER displace a paying customer. Looking at it from another perspective, any displacement of paying customers is a non-event accounting-wise, since that customer's revenue was never booked in the first place.
In my opinion the first perspective is more accurate. A company which allows the use banked points to displace a large fraction of its revenue will go out of business. Foregone future revenue should not be ignored in present accounting, or else bad decisions will result. As they obviously have.
I should note that this incremental cost accounting for flight miles is used by most airlines, but that airlines are permitted to chose to defer more revenue according to the redemption value of the points, using the IFRIC 13 rules. You can guess why they do not make that choice.
Points in the second bucket are not carried as a liability, but neither is the revenue recognized until the points are redeemed or expire unused. This treatment, which is required by IFRIC 13, seems eminently fair, but there is one catch. If at any time the estimated cost of award redemption exceeds the money received for the points from the third party, the airline must immediately recognize a loss for the excess.
Southwest was the first large airline to adopt revenue-based redemption. I will use their program as an example.
We know that airlines sell their miles and points to third parties at around 1 cent each. How did it make sense in 2011 for Southwest to sell 1.67 cents of travel for 1 cent? Was Southwest merely borrowing from its future revenue at a high rate of interest? I believe they were.
Southwest presumably believed that people redeeming points would be taking trips for which they would not have paid the cash price. In a "points are as good as cash"revenue-based redemption program such as the current Rapid Rewards, that proposition is not credible. In the current (until April 17, 2015) program, each redemption reduces Southwest's revenue by 1.43 cents per point. (Southwest devalued its points by a ratio of 6/7 in March 2014.)
Southwest presumably also believed that few award tickets would displace paying passengers. When load factors were low, this belief was reasonable. With high load factors, a much larger percentage of redemption occurs on sold out flights, meaning that some revenue has been lost from other customers in addition to any lost revenue from the person redeeming points.
Loyalty programs face the challenge of providing customers with more than 1 cent of perceived value per point while losing less direct revenue than they gain by selling those points. In other words, loyalty programs need to create enough of a value wedge to be able to give the third party a cut of that wedge. It is not at clear to me that revenue-based redemption can ever be compatible with creating such a value wedge. To me, revenue-based redemption looks like a dead end, creating revenue today which is more than matched by decreased revenue in the future.
Southwest appears to have reached a similar conclusion. It has decided to tilt its redemption rates in favor of flights which will not sell out. This is a soft version of capacity controls, the lack of which was the prime selling point of revenue-based redemption. Current accounting rules seem incompatible with any program which does not include some form of capacity controls.
To the extent that redemption on 100% full flights decreases under Southwest's new rules, displacement of revenue purchases will decrease. However there is still the lost revenue from the member who is redeeming points. I don't see how one can deny that in most cases the member redeeming points would have paid cash for that flight. When you provide the member 1.43 cents per point of redemption value, you are losing approximately 1.43 cents of revenue from that member. If you only received 1 cent per point from Chase, you just lost 0.43 cents per point in the real world, regardless of how you do your accounting.
If you devalue points further and force the member to redeem at 1 cent per point, you eliminate this loss. However members will drop their affiliate credit cards in favor of cards offering 1% to 2% straight cash back. Chase will no longer pay 1 cent per point, and the whole scheme of selling points to third parties will collapse. It seems to me that revenue-based redemption puts the loyalty program in a coffin corner situation where it cannot devalue the points yet it cannot maximize the company's revenue either.
Chart-based redemption programs face some of these problems, but the charts offer members the possibility of outsized value for a particular redemption. In those cases the airline does not lose revenue because the member would not have paid the cash price and because the flight is not 100% full (as ensured by capacity controls). The classic mileage program structure is therefore sustainable as long as the awards attract sufficient numbers of people to affiliate credit cards.
One other detail. Southwest continues to offer zero-fee last minute redemption and redeposit. Paid tickets are similar, but the travel funds become limited to one year and locked to that one passenger, who might be an infrequent traveler. This difference make a points ticket slightly more valuable than a cash ticket. I estimate this effect at 5% or less in value, but it does contribute to Southwest's value wedge. Even if one believes that this difference will continue, I don't think it's enough to keep Southwest's program going in anything closely resembling its current form.
Is any "points as good as cash" loyalty program inevitably doomed? I look forward to readers' perspectives on this question.
If miles and points were recorded at the time of issuance as a liability at their redemption value, airlines would have little incentive to "print" their currencies without limit. An overly generous frequent flyer program would be seen immediately as a loss-creating enterprise. But the accounting treatment does not work that way. Overly generous programs are common, with accounting rules concealing the losses for several years until reality creeps in and forces the airline to devalue its miles or points.
Let's look at the incentives created by the accounting rules. Most airlines account for miles or points in two buckets. The first bucket is points earned by flying. The second bucket is points sold to third parties, primarily banks.
Under IAS 18 Paragraph 19, points in the first bucket are NOT carried as a liability, except to the extent that an airline will incur small marginal costs to carry a passenger in an otherwise empty seat. You could look at this accounting treatment from one perspective as saying that a points redemption will NEVER displace a paying customer. Looking at it from another perspective, any displacement of paying customers is a non-event accounting-wise, since that customer's revenue was never booked in the first place.
In my opinion the first perspective is more accurate. A company which allows the use banked points to displace a large fraction of its revenue will go out of business. Foregone future revenue should not be ignored in present accounting, or else bad decisions will result. As they obviously have.
I should note that this incremental cost accounting for flight miles is used by most airlines, but that airlines are permitted to chose to defer more revenue according to the redemption value of the points, using the IFRIC 13 rules. You can guess why they do not make that choice.
Points in the second bucket are not carried as a liability, but neither is the revenue recognized until the points are redeemed or expire unused. This treatment, which is required by IFRIC 13, seems eminently fair, but there is one catch. If at any time the estimated cost of award redemption exceeds the money received for the points from the third party, the airline must immediately recognize a loss for the excess.
Southwest was the first large airline to adopt revenue-based redemption. I will use their program as an example.
We know that airlines sell their miles and points to third parties at around 1 cent each. How did it make sense in 2011 for Southwest to sell 1.67 cents of travel for 1 cent? Was Southwest merely borrowing from its future revenue at a high rate of interest? I believe they were.
Southwest presumably believed that people redeeming points would be taking trips for which they would not have paid the cash price. In a "points are as good as cash"revenue-based redemption program such as the current Rapid Rewards, that proposition is not credible. In the current (until April 17, 2015) program, each redemption reduces Southwest's revenue by 1.43 cents per point. (Southwest devalued its points by a ratio of 6/7 in March 2014.)
Southwest presumably also believed that few award tickets would displace paying passengers. When load factors were low, this belief was reasonable. With high load factors, a much larger percentage of redemption occurs on sold out flights, meaning that some revenue has been lost from other customers in addition to any lost revenue from the person redeeming points.
Loyalty programs face the challenge of providing customers with more than 1 cent of perceived value per point while losing less direct revenue than they gain by selling those points. In other words, loyalty programs need to create enough of a value wedge to be able to give the third party a cut of that wedge. It is not at clear to me that revenue-based redemption can ever be compatible with creating such a value wedge. To me, revenue-based redemption looks like a dead end, creating revenue today which is more than matched by decreased revenue in the future.
Southwest appears to have reached a similar conclusion. It has decided to tilt its redemption rates in favor of flights which will not sell out. This is a soft version of capacity controls, the lack of which was the prime selling point of revenue-based redemption. Current accounting rules seem incompatible with any program which does not include some form of capacity controls.
To the extent that redemption on 100% full flights decreases under Southwest's new rules, displacement of revenue purchases will decrease. However there is still the lost revenue from the member who is redeeming points. I don't see how one can deny that in most cases the member redeeming points would have paid cash for that flight. When you provide the member 1.43 cents per point of redemption value, you are losing approximately 1.43 cents of revenue from that member. If you only received 1 cent per point from Chase, you just lost 0.43 cents per point in the real world, regardless of how you do your accounting.
If you devalue points further and force the member to redeem at 1 cent per point, you eliminate this loss. However members will drop their affiliate credit cards in favor of cards offering 1% to 2% straight cash back. Chase will no longer pay 1 cent per point, and the whole scheme of selling points to third parties will collapse. It seems to me that revenue-based redemption puts the loyalty program in a coffin corner situation where it cannot devalue the points yet it cannot maximize the company's revenue either.
Chart-based redemption programs face some of these problems, but the charts offer members the possibility of outsized value for a particular redemption. In those cases the airline does not lose revenue because the member would not have paid the cash price and because the flight is not 100% full (as ensured by capacity controls). The classic mileage program structure is therefore sustainable as long as the awards attract sufficient numbers of people to affiliate credit cards.
One other detail. Southwest continues to offer zero-fee last minute redemption and redeposit. Paid tickets are similar, but the travel funds become limited to one year and locked to that one passenger, who might be an infrequent traveler. This difference make a points ticket slightly more valuable than a cash ticket. I estimate this effect at 5% or less in value, but it does contribute to Southwest's value wedge. Even if one believes that this difference will continue, I don't think it's enough to keep Southwest's program going in anything closely resembling its current form.
Is any "points as good as cash" loyalty program inevitably doomed? I look forward to readers' perspectives on this question.
Feb 15, 2015, 6:17 pm
#2
Original Member
Join Date: May 1998
Posts: 1,139
I think the devaluations will continue, but honestly I think your analysis is a bit too accounting oriented instead of economics oriented.
The frequent flier programs started when there were too many airlines with too many open seats. The airlines were losing money, and if they continued to sell too many low-priced seats to last minute purchasers, it just made things worse.
So a few airlines started this cheesy fly six times and your next one is free program, and it worked. A customer was relatively more likely to fly American than its competitors as a result of the frequent flier program. Then the rest of the airlines started the same program, and the competitive advantage was lost.
Then when the Great Recession happened, and the airlines needed every dollar they could get, they sold massive quantities of miles to credit card companies who gave them out for free. And when they weren't free from a sign-up bonus, techniques such as The Mint and Manufactured Spending at least make them very low cost.
But some very interesting things happened between 9/11/01 and the end of the Great Recession. The airline mergers made them Too Big To Fail and eliminated excess capacity. Now the decline in the price of oil raises the possibility of huge airline profitability from selling every seat for cash and the increase in the value of the dollar compared to other currencies will stimulate demand for international travel from the U.S., including demand for the enhanced premium cabin travel.
If I were advising an airline, I would tell them to massively devalue their miles. Sell those seats for cash instead of giving them away! The airline already has their cash from transferring the miles for cash. If the mileage holders are angry, what can they do? The few other airlines existing in this new oligopoly are devaluing at the same time.
Tell me why, from an economics perspective, they should not massively devalue?
The frequent flier programs started when there were too many airlines with too many open seats. The airlines were losing money, and if they continued to sell too many low-priced seats to last minute purchasers, it just made things worse.
So a few airlines started this cheesy fly six times and your next one is free program, and it worked. A customer was relatively more likely to fly American than its competitors as a result of the frequent flier program. Then the rest of the airlines started the same program, and the competitive advantage was lost.
Then when the Great Recession happened, and the airlines needed every dollar they could get, they sold massive quantities of miles to credit card companies who gave them out for free. And when they weren't free from a sign-up bonus, techniques such as The Mint and Manufactured Spending at least make them very low cost.
But some very interesting things happened between 9/11/01 and the end of the Great Recession. The airline mergers made them Too Big To Fail and eliminated excess capacity. Now the decline in the price of oil raises the possibility of huge airline profitability from selling every seat for cash and the increase in the value of the dollar compared to other currencies will stimulate demand for international travel from the U.S., including demand for the enhanced premium cabin travel.
If I were advising an airline, I would tell them to massively devalue their miles. Sell those seats for cash instead of giving them away! The airline already has their cash from transferring the miles for cash. If the mileage holders are angry, what can they do? The few other airlines existing in this new oligopoly are devaluing at the same time.
Tell me why, from an economics perspective, they should not massively devalue?
Last edited by Andy2; Feb 15, 2015 at 6:28 pm
Feb 15, 2015, 6:49 pm
#4
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Because of the black swans. The dollar may make foreign travel look good, but things like airplanes dropping from the sky and terrorist attacks may suddenly curb demand. You can never predict when the herd will suddenly stampede or we would all be rich playing real estate and the stock market. Delta is tap dancing in a minefield by turning on its customers. 
I think the devaluations will continue, but honestly I think your analysis is a bit too accounting oriented instead of economics oriented.
The frequent flier programs started when there were too many airlines with too many open seats. The airlines were losing money, and if they continued to sell too many low-priced seats to last minute purchasers, it just made things worse.
So a few airlines started this cheesy fly six times and your next one is free program, and it worked. A customer was relatively more likely to fly American than its competitors as a result of the frequent flier program. Then the rest of the airlines started the same program, and the competitive advantage was lost.
Then when the Great Recession happened, and the airlines needed every dollar they could get, they sold massive quantities of miles to credit card companies who gave them out for free. And when they weren't free from a sign-up bonus, techniques such as The Mint and Manufactured Spending at least make them very low cost.
But some very interesting things happened between 9/11/01 and the end of the Great Recession. The airline mergers made them Too Big To Fail and eliminated excess capacity. Now the decline in the price of oil raises the possibility of huge airline profitability from selling every seat for cash and the increase in the value of the dollar compared to other currencies will stimulate demand for international travel from the U.S., including demand for the enhanced premium cabin travel.
If I were advising an airline, I would tell them to massively devalue their miles. Sell those seats for cash instead of giving them away! The airline already has their cash from transferring the miles for cash. If the mileage holders are angry, what can they do? The few other airlines existing in this new oligopoly are devaluing at the same time.
Tell me why, from an economics perspective, they should not massively devalue?
The frequent flier programs started when there were too many airlines with too many open seats. The airlines were losing money, and if they continued to sell too many low-priced seats to last minute purchasers, it just made things worse.
So a few airlines started this cheesy fly six times and your next one is free program, and it worked. A customer was relatively more likely to fly American than its competitors as a result of the frequent flier program. Then the rest of the airlines started the same program, and the competitive advantage was lost.
Then when the Great Recession happened, and the airlines needed every dollar they could get, they sold massive quantities of miles to credit card companies who gave them out for free. And when they weren't free from a sign-up bonus, techniques such as The Mint and Manufactured Spending at least make them very low cost.
But some very interesting things happened between 9/11/01 and the end of the Great Recession. The airline mergers made them Too Big To Fail and eliminated excess capacity. Now the decline in the price of oil raises the possibility of huge airline profitability from selling every seat for cash and the increase in the value of the dollar compared to other currencies will stimulate demand for international travel from the U.S., including demand for the enhanced premium cabin travel.
If I were advising an airline, I would tell them to massively devalue their miles. Sell those seats for cash instead of giving them away! The airline already has their cash from transferring the miles for cash. If the mileage holders are angry, what can they do? The few other airlines existing in this new oligopoly are devaluing at the same time.
Tell me why, from an economics perspective, they should not massively devalue?
Feb 15, 2015, 6:52 pm
#5
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We also are just assuming that Chase is paying .01, but don't know that for a fact. I suggest the Diners Club conversion ratio of 1.25:1 as a hint that it might be higher than a penny a point.
There would still be a disparity long-term between Southwest selling to Chase at 1.25 and redeeming to pax at 1.43 as NSX suggested.
There is an X factor that would justify losing money on points. The value of customer loyalty generated from Rapid Rewards.
There would still be a disparity long-term between Southwest selling to Chase at 1.25 and redeeming to pax at 1.43 as NSX suggested.
There is an X factor that would justify losing money on points. The value of customer loyalty generated from Rapid Rewards.
Feb 15, 2015, 7:13 pm
#6
Original Member
Join Date: May 1998
Posts: 1,139
Because of the black swans. The dollar may make foreign travel look good, but things like airplanes dropping from the sky and terrorist attacks may suddenly curb demand. You can never predict when the herd will suddenly stampede or we would all be rich playing real estate and the stock market. Delta is tap dancing in a minefield by turning on its customers.
I do not see any of the big airlines taking a position that miles were worth X when they were earned, and we are going to devalue existing miles at all. The issue is how low they will go, with AA, UA and WN going just not quite as low as Delta. The foreign carriers such as BA and Virgin will not require as many miles but will continue to increase their "cash fee for tax reimbursement" to a level that makes their programs virtually useless.
And even if things turn bad again, I do not see airlines needing to turn to the sell of miles to wholesalers to survive. That was yesterday's technique before the industry became an oligopoly.
My premise is that mileage earners are no longer important to the economics of the airline itself, and there is no reason for them to fear a "stampede" like you describe. There is no where for the herd to go, and the other airlines have little interest in customers who really want to fly all over the world in premium class without paying any real cash to the airline. The best days are behind us. Hope that everyone enjoyed them.
Last edited by Andy2; Feb 15, 2015 at 8:01 pm
Feb 15, 2015, 7:34 pm
#7
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Feb 15, 2015, 7:59 pm
#8
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Classic!
Talk about devaluation, to live in the "good old days", I got the following for a single 50,000 mile award on TWA:
- One round-trip first class ticket anywhere in the world. I flew BOS-TLV-BOS.
- One first class upgrade on any fare to anywhere in the world. I used it on another BOS-TLV-BOS.
- One week rental car.
- One week in a hotel (I can't remember which chain).
- Some other coupons that I can't recall.
Feb 15, 2015, 8:19 pm
#10
Original Member
Join Date: May 1998
Posts: 1,139
Classic!
Talk about devaluation, to live in the "good old days", I got the following for a single 50,000 mile award on TWA:
Talk about devaluation, to live in the "good old days", I got the following for a single 50,000 mile award on TWA:
- One round-trip first class ticket anywhere in the world. I flew BOS-TLV-BOS.
- One first class upgrade on any fare to anywhere in the world. I used it on another BOS-TLV-BOS.
- One week rental car.
- One week in a hotel (I can't remember which chain).
- Some other coupons that I can't recall.
Just out of curiosity, how full were the flights? I am guessing not completely full.
These programs were built on the premise that customers would be more likely to buy revenue tickets on a given airline (instead of one of the other eight competitors) and it was no big deal to give that customer a nice free seat on just about any flight because there would be plenty of otherwise unsold seats.
Now that there are fewer airlines and every seat might actually be sold at a cash profit, allowing mileage redemptions have a true negative cash consequence to the airline, and there is no reason not to devalue, particularly if your few true competitors are doing a similar devaluation.
This is the golden age of being an airline shareholder, and is (of will soon be) the worst time to be a customer, particularly a customer who tries to take most of his or her trips using miles.
Feb 15, 2015, 8:31 pm
#11
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Literally. I stole it from Blaise Pascal, the guy who has his own triangle.
Last edited by nsx; Feb 15, 2015 at 9:04 pm
Feb 15, 2015, 8:45 pm
#12
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Join Date: May 1998
Posts: 1,139
Literally. I stole it from Blaise Pascal.
In my opinion, the accounting would have been more accurate if it completely ignored frequent flier miles. The terms and conditions create no legal liability to the airline with respect to future redemptions of unused miles, and no one can accurately determine the value, if any, of the miles, so it would have been better if no future liability is created when the miles are issued. Any attempt to predict the future just creates problems.
Feb 15, 2015, 8:47 pm
#13
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I honestly think the FFP's has matured enough that airlines (some of them anyway) can feel fairly confident in the amount of data that has been collected to do lots of analytical slicing and dicing to come to the conclusion that they have left money on the table, or at least feel like they are giving away too much.
More simply put, they are getting more greedy thanks to all the ways technology has now enabled them to understand their customers and market. The US airline industry, in its current state, also allows them to get away with it.
I'm sure there are additional operational/economic pressures to squeeze the FFP from a loyalty-based model to one that is based purely on revenue reward, but the key enablement to do it now vs before is their ability to make those calculations/forecasts and the industry consolidation which does not give customers many options.
More simply put, they are getting more greedy thanks to all the ways technology has now enabled them to understand their customers and market. The US airline industry, in its current state, also allows them to get away with it.
I'm sure there are additional operational/economic pressures to squeeze the FFP from a loyalty-based model to one that is based purely on revenue reward, but the key enablement to do it now vs before is their ability to make those calculations/forecasts and the industry consolidation which does not give customers many options.
Feb 16, 2015, 6:27 am
#14
Join Date: Dec 2007
Posts: 3,607
Are all "points as good as cash" loyalty programs inevitably doomed?
Why would you keep flying a route that you regularly don't sell out?
I think this is the main driver of the FF devaluation. The programmes existed to give away some of the excess inventory in a way that extracted some minimal value in the form of future purchases. As the businesses have gotten more efficient there's less excess inventory. We're reaching the light where there's really no significant excess inventory. Airlines have such meagre margins that they can't afford to keep flying routes with any empty seats.
So any award seat now represents forgone revenue. Any accounting system that doesn't represent that will lead airlines to issue points they can't cash and force them to devalue.
I think this is the main driver of the FF devaluation. The programmes existed to give away some of the excess inventory in a way that extracted some minimal value in the form of future purchases. As the businesses have gotten more efficient there's less excess inventory. We're reaching the light where there's really no significant excess inventory. Airlines have such meagre margins that they can't afford to keep flying routes with any empty seats.
So any award seat now represents forgone revenue. Any accounting system that doesn't represent that will lead airlines to issue points they can't cash and force them to devalue.
Last edited by zkzkz; Feb 17, 2015 at 11:15 am Reason: phone keyboard typo