Credit cards are expensive. According to BankRate.com the average US annual percentage rate (APR) charges on credit cards is 15.35%[1], but that’s down in recent years. During the financial crisis some US-based credit card APRs went as high as 39.6%[2] as banks like Bank of American tried to compensate for increasing risk, or unwind high-risk credit that was being carried by the bank. In the UK credit card rates hit a 13-year high in 2011, averaging out at 18.9% annually[3].

In some cases customers who had maintained a good credit rating, but were otherwise in the marginal zone of profitability, were targeted for perceived risk (re-adjusted due to the financial crisis) – this prompted some customers to creatively respond to these rate increases with very public rants against the banks involved.

The core problem with credit cards today for consumers is that they are fundamentally designed to encourage spending, in order to generate revenue for card companies and issuing banks. While debit cards are marginally better for consumers on an interest rate perspective, the lack of visibility on spend and overdraft fees means that in the US the average consumer pays $225.00 in fees per year[4] on a debit card/checking account – that includes all those “free” checking accounts, which are anything but!

According to CreditCards.com and TransUnion research from May this year, the average credit card debt per U.S. adult (excluding zero-balance cards and store cards) is $4,878, on the basis of average APR this means interest costs in one year alone would cost a consumer well over $600 – and that’s without paying down the card debt. Regardless of the construct, cards generally are expensive propositions for customers.

So if you are a bank or card issuer how do you convince customers to pay all those expensive fees, use the cards with greater frequency and increase the likelihood of expensive revolving credit?

The hook – rewards and cash back

The answer, of course, was card “reward” programs. The more you spend, the more free stuff you get, and even cash back on your purchases!

Reward programs can be traced back as far as the 1896 when Thomas Sperry and Shelly Hutchinson created a business that issued “S&H Green Stamps” (also known as Green Shield Stamps) which could be earned by consumers making purchases at participating supermarkets, department stores, gas stations, and retailers. During the 1960s, the S&H rewards catalog was the largest stand-alone publication (by distribution) in the United States, and it is said that S&H printed three times the number of stamps that the US Postal Service[5] at its peak.

In the 1970s Airlines jumped on board the ‘rewards’ concept with gusto. Wikipedia explains the history:

The very first modern frequent-flyer program was created in 1972 by Western Direct Marketing, for United Airlines. It gave plaques and promotional materials to members. In 1979 Texas International Airlines created the first frequent-flyer program that used mileage tracking to give 'rewards' to its passengers, while in 1980 Western Airlines created its Travel Bank, which ultimately became part of Delta Air Lines' program upon their merger in 1987.
Wikipedia – Frequent-Flyer Program article

It wasn’t until almost two decades later that credit card issuers caught on to rewards as a stimulus, and even then it wasn’t a bank that first offered rewards with a credit card - it was AT&T. In 1986 AT&T launched their Universal Card Credit Card with “Thank You Rewards”[6], closely followed by Discover’s “cash back” program. Today over 60 percent of credit cards in the US are linked to reward programs[7].

The problem is that rewards programs are designed to encourage frequency. For airlines the purpose is to encourage you to fly. For credit and debit cards, they are designed to encourage you to spend, even when doing so carries a high cost. The economics of rewards programs are pretty simple – companies employing them wouldn’t use rewards unless these programs were highly successful in generating more than enough revenue to pay their way. While individual users of reward programs might gain some benefit, they are outliers. The rewards themselves are designed such that users of the card or airline pay a premium in return for marginal rewards, negating the benefit under cost-benefit analysis.

Even with reward propositions, a large percentage of consumers fail to redeem rewards on programs they sign up for. Clear Point Credit Counseling Solutions calculates that up to one third of consumers on credit cards fail to cash in their points annually.

"It's actually a pretty wide spread problem, about a third of the people who have rewards points forget to cash out on them and it's about an average of 205 dollars of [lost] savings for each consumer," Rebecca Gershowitz, Clear Point Credit Counseling Solutions[8]

The real cost of loyalty and frequency

In the early 2000’s I did extensive work with Cathay Pacific and their Asia Miles program. Cathay was always trying to encourage the use of non-air miles redemption because it allowed the airline to run the program at lower costs, and they could trade off promotions and the purchase of miles to the merchants who offered their products into the Asia Miles catalog. This was always a challenge, because Asia Miles was their frequency program, and customers at that end of the spectrum were all about “fly free faster”. The most loyal Cathay Pacific customers, the Marco Polo Club members, were largely ambivalent when it came to miles/rewards, because for them it was all about recognition – getting the occasional upgrade, shorter queues, boarding faster, lounge access, etc.

Herein lies the problem. Those consumers that find the highest value in reward programs are generally at the lower end of the profitability scale, and while rewards might stimulate greater frequency (the jury is still out on that front[9]) – membership recognition is actually better at stimulating loyalty for the most profitable customers.

At the frequency end of the reward program, however, things generally work as long as there are enough program participants that don’t use their rewards, letting their points or miles lapse. This clearly is a challenge - Aité Group research in 2009[10] showed that profitability eludes most of the card reward programs already in operation. Research in 2013 coming out of Ryerson University in Ontario, Canada, suggests that customers’ satisfaction plays a significant role in profitability of loyalty programs, and that depending on overall customer satisfaction, it may be optimal not to offer rewards at all[11].

Enter Smartphone Loyalty

Smartphones have significantly lowered the friction in accessing and redeeming rewards, points or miles these days. While companies like Starbucks and some electronic retailers have used this to stimulate activity, the decrease in friction, and subsequent increase use or claiming of rewards spells trouble for credit card programs in particular.

Recent research from CloudZync, an e-Wallet technology provider, shows that the average customer now has access to six different loyalty schemes on their phone. While the CloudZync research focuses on the UK market, it shows that loyalty program usage has gone up across the board, and has significantly affected sectors like electronic retailers, supermarkets and clothing chains[12].

As smartphone usage increases rewards becomes easier and easier to redeem, there will be a decrease in the net number of customers who no longer claim rewards, and therefore marginal profitability will be hammered.

GenY’s also appear much more attuned to the notional opportunity cost of rewards built into credit card schemes in particular, where they are not convinced of the trade-off between higher interest rates, frequency of spend and the tangible value of the reward. Even for cash back offers, it doesn’t require much of a revolving balance over a couple of months for a consumer to wipe out any cash-back benefits.

Transparency on fees is much more of an issue today for consumers than those in the early 90s who were entering the credit card market. As modality of payments shift to the phone, card proxies will be more about payments utility, account or wallet feature set and overall ease of use, than the rewards that stimulate spending. In fact, it is likely that contextual use of a card proxie on the phone, including transparency on balance and real fees, will generate significant push back on any card program that attempts to stimulate spending at all.

In the era of the quantified self – the self-aware customer won’t make spending decisions based on cash-back, miles or trinkets offered – they’ll make spending decisions based on whether they can afford to make a purchase.

As we reach that point over the next 3-4 years, card programs will largely become a thing of the past, because I don’t care how you want to make me spend money – if I can’t afford it, I won’t spend it.

[1] Source: BankRate.com Oct 2013 – Variable APR (15.35%), Fixed APR (13.02%) http://www.bankrate.com/finance/credit-cards/rate-roundup.aspx

[2] See http://piggington.com/what_is_the_highest_credit_card_apr_you_are_seeing

[3] Daily Mail, Feb 2011 - Credit card rates hit a 13-year high, leaving families squeezed by average interest of 18.9% - http://www.dailymail.co.uk/news/article-1352671/Credit-card-rates-hit-13-year-high-average-18-9.html#ixzz2jcTzKFAk

[4] Source: Consumer Finance Protection Bureau research as highlighted via CNNMoney June, 2013 - http://money.cnn.com/2013/06/11/pf/overdraft-fees/

[5] Source: Wikipedia Article – S&H Green Stamps

[6] See - http://www.universalcard.com/us/cards/ucs/personal/onlineservices.jsp

[7] Source: CreditCard.com

[8] Source: NBC News – “Unclaimed Reward Points”

[9] See Consumer Psychologist Examines Effectiveness of Reward Programs (Phys.org)

[10] Financial Services Rewards Programs: The Quest for Profitability (2009, Aite Group)

[11] Profitability of loyalty reward programs: An analytical investigation (A. Gandomi, S. Zolfaghar – August 2013)

[12] See Consumers ditch physical loyalty cards for mobile – with electrical retailers leading the charge (Oct 30, 2013) – InternetRetailing.net