How Brands Can Build Better Loyalty Programs

Consumers today often belong to a host of retailer ‘loyalty programs,’ earning redeemable points when they spend. In many cases, there is no extra reward for building up a high balance of points in your account. So why do so many people stockpile their points?

This is the question explored by Wharton doctoral student Valeria Stourm and marketing professors Eric T. Bradlow and Peter S. Fader in their paper, “Stockpiling Points in Linear Loyalty Programs,” recently published in the Journal of Marketing Research. In this interview with Knowledge@Wharton, Fader talks about what the trio learned, what it means for the businesses that use loyalty programs and how this peculiar hoarding behavior reflects a phenomenon at the heart of consumer psychology.

An edited transcript of the interview appears below.

More Points, Same Status

These days, everybody’s talking about loyalty programs. Whether you’re a consumer collecting points and then using them to buy things, or whether you’re a firm offering different kinds of programs, we want to have a really good understanding of different kinds of loyalty programs. For instance, in a lot of programs out there — like the airlines and many other companies — when you accumulate a certain number of points, your status changes or the value of your points is greater than it was before. But in many, many programs, there’s none of that. It’s just a “linear” program: You get a certain amount of points every time you spend a dollar, and you can turn those points back into dollars when you buy things.

But nothing really changes. You can accumulate points, but the rates don’t change, your status doesn’t change. So linear loyalty programs are kind of boring, but they’re really, really common, and there’s some really interesting phenomena that happen around them.

For instance, a few years ago, one of my MBA students came to me: His family runs a chain of retail stores in Central America, and they have a very standard linear loyalty program. And he noticed something really curious. In a linear loyalty program, customers should just be spending those points right away. There is no benefit to accumulating them. There’s nothing to be gained from stockpiling them. The only thing that can happen is you can lose them, or the company can go out of business.

“In a linear loyalty program, customers should just be spending those points right away. There is no benefit to accumulating them.”

But people stockpile points in a linear program, and it’s weird. It’s not that they’re never using the points. Occasionally, they will use them, but they pile them up and pile them up and pile them up, and then use a few and then pile them up again. So why is it that people pile up points in a linear loyalty program? This former student posed this as a puzzle and it became a very interesting research program and I was really happy to work with one of my Ph.D. students, Valeria Stourm and one of my colleagues, Eric Bradlow, to come up with a statistical model that will sort out lots of different explanations.

Why is it that people pile up points in a linear loyalty program? We considered lots of different factors, some psychological, some economic and tried to sort them all out to figure out what the winning explanations were. That’s what the paper’s all about.

Why People Won’t Spend Their Points

We looked at lots of different explanations. Maybe it’s the case that it’s so burdensome on you to think about the points that you only do it once in a while. Or maybe you’re afraid of using up the points, because then you won’t get points on that particular transaction. But the main explanation that we came up with was something that honestly we didn’t even think about in advance, although there’s very strong psychological theory underlying it. That’s the idea that, in people’s minds, they have two separate accounts. They have a cash account: How much money do I have and how much money would I be losing if I buy this product? But they also have a points account: How many points do I have, and how many points would I gain or lose if I buy this product, if I use points or if I don’t use points? So people have these “mental accounts.” And they’re different.

It’s not that points and dollars are equally interchangeable. Some theory tells us that people would be a little bit more sensitive to losing cash than they would be to losing points — that is, redeeming them.

You have these two different accounts and different sensitivities about how you’d make tradeoffs between them. The basic idea is, I’m looking at a purchase, I’m thinking about how many points I have, I’m thinking of how much cash I have, I’m thinking of how many points I would lose or how much cash I would lose, depending on how I buy it, and I’m going to … choose the account that makes me happiest.

“It’s important to understand that the way that people approach something that should be economic is often much more psychological.”

It’s this idea of mental accounting that explains why people will often pile up points and don’t use them, even though economically, they should just be using them all the time. Twitter 

Key Takeaways

Now that we know that people have these two mental accounts, there are all kinds of important implications. First of all, it’s just interesting to know about how people operate, and to be able to predict who is likely to redeem how often and when. It’s very important for retailers to have some idea about what these redemptions are going to look like. After all, as people are piling up all these points, they’re building up all these liabilities on the business’s balance sheet. As a business, you want to know when these redemptions are going to occur and you want to set up your program in a way so you have the “just right” number of redemptions. You might not want people redeeming all the time, because then they come to expect it. But you don’t want them to be redeeming too infrequently because then you have these really big point liabilities on your balance sheet.

One of the big takeaways from the paper is that by having our multiple accounts story, we can give retailers specific advice about different parameters of their loyalty programs: How many points do we give you for each dollar that you spend? How many dollars are the points worth when you redeem them? We can help you come up with that just-right combination to make sure that you’re getting that just-right blend of people redeeming their points, but not too often.

Underlying Psychological Drivers

What makes this project unique, first of all, is that really tight focus on linear loyalty programs. They’re really, really common, so it’s surprising how little research has been done on them. Part of it is that they’re just not as sexy and dramatic and interesting as programs where you have to hit certain thresholds. What are the psychological mechanisms that get people to get to those thresholds? Linear programs are boring — but they’re an important part of business.

We really want companies to have a better understanding about how they operate, what are the economics associated with them, and what are the underlying psychological drivers that describe how people use them and how they would respond differently if companies were to change certain aspects of the program.

Another important aspect of this research is this idea of having these two mental accounts. Very often, when you look at loyalty programs, you tend to think that people are very rational and they’re making these very utilitarian tradeoffs between the points they have and the dollars they have, and they’re always optimizing.

Well, that’s not true. A lot of this “mental accounting” that we’re leveraging, a lot of this is work that goes back to Daniel Kahneman and Amos Tversky, two terrific, world-class psychologists. Daniel Kahneman won the Nobel Prize for some of his work. This mental accounting occurs all the time, even in situations where you might not expect to see it, so it’s important to understand that the way that people approach something that should be economic is often much more psychological. And I think the story that we tell, about these two different accounts and how they differ from each other and how it leads to a very elegant solution to a very practical real-world puzzle is a very nice contribution by itself.

“We can help you come up with that just right combination to make sure that you’re getting that just-right blend of people redeeming their points, but not too often.”

What’s Next

The lead author on this paper is one of my Ph.D. students, Valeria Stourm, and she’s been just captivated by this idea of loyalty programs, the psychological drivers underneath them, and the economic implications that arise from them. This was just one paper that Valeria and Eric Bradlow and I did together. Valeria’s working on her dissertation now, on a different kind of loyalty program with a different company in a different part of the world — in this case, trying to understand the nature of a coalition loyalty program.

Very often, instead of just one company having its own loyalty program, you’ll have a loyalty program that lots of different companies belong to. For instance, American Express recently announced a program called Plenty that’s a coalition loyalty program, because you can accumulate points from lots of different companies like AT&T, for instance, and many others and use those points at a variety of different firms, not necessarily the firms that you got the points from.

A coalition loyalty program is another emerging loyalty program idea, not quite as common, at least in the U.S., as your standard airline loyalty program, but very big around the world, and it’s very important to understand how you develop one, how you set the parameters for it. What are the exchange rates? How should it vary? Under what conditions would a firm want to be part of the coalition loyalty program? We’re just scratching the surface to try to really understand loyalty programs, inside and out. And as much as we keep expanding our research that involves them, the number and the variety of loyalty programs are expanding even more. So we’re going to have a hard time keeping up with the loyalty program industry, but we’re having a real good time learning about the nature of these programs as we go along.

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