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The Psychology of Loyalty Programs 

David Feldman | Aug 5, 2016 1,423 views 4 Comments

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The reward proposition is what drives customer behavior

I recently had the opportunity to speak at the [email protected] Awards conference in Las Vegas, where I spoke about customer engagement.

One aspect of my comments which elicited numerous questions over the following days was about the relevance of psychological and behavioral motivation to loyalty programs.

The real currency of any loyalty program lies in its ability to drive changes in consumer behavior.

But what behavior would we like to change / drive?

When designing, evaluating or changing a loyalty program — the first step program managers need to take is to clarify the strategic objectives of the program.

Loyalty programs can do many things, such as:

  • Preventing customers from switching / defecting to competitors;
  • Provide insights into consumer preferences;
  • Drive incremental spend and increased demand;
  • Increase share-of-wallet;
  • Be profitable in their own right (just look at airline Frequent Flyer Programs).

Using airline & hotel loyalty programs as an example, we can simplify program strategies to 3 key goals:

  • INCREASE FREQUENCY :
    Getting the customer to fly our airline or stay in our hotel more often .
  • INCREASE SPEND :
    Getting customers to purchase higher fares, better rooms and engage with high-margin ancillary and partner products .
  • INCREASE AFFINITY :
    We want them to love our brand and our product. We want them excited about offers that we send them. We want them to tell their friends and colleagues about us. And ultimately, we want to get them to form an emotional attachment with us in order to progress to a state of true loyalty .

It is imperative that the behaviors we seek to drive from our customers are aligned with our strategic goals.

So we know we want to get our customers to fly more often, spend more money and tell their friends how awesome we are — but how does psychology help us?

REINFORCEMENT

One of the most important concepts for loyalty programs is the theory of reinforcement. Most people understand the idea of reinforcement.

Whether you’re training your dog to sit, getting your kids to do their homework or ensuring your employees turn up to work — reinforcement is everywhere.

B.F. Skinner developed the concept of operant conditioning. The basic idea is that behavior which is followed by a reward (positive reinforcer) is more likely to recur.

Relevant to loyalty programs are the five schedules of reinforcement including continuous, fixed interval (FI), fixed ratio (FR), variable interval (VI) and variable ratio (VR).

Being rewarded with a free flight after earning 25,000 miles is an example of fixed ratio (FR) reinforcement. So is earning elite status after staying 50 nights at a hotel brand.

By advertising a set of rewards to customers in return for specified behaviors (eg. reaching flight / spend / stay thresholds) and then rewarding them for achieving those thresholds ; you can encourage customers to keep engaging in the desired behaviors.

Conversely, removing the reward (“reinforcer”) by way of devaluing your program and removing benefits — will result in an erosion of loyalty due to customers no longer performing the behavior.

Skinner defines this process as “extinction”. In other words, when the desired behavior is no longer reinforced, the behavior will gradually stop occurring.

One challenge for frequent flyer programs is to get the design of reinforcement schedules right. Rewarding a behavior too often can result in excessive marketing costs. On the other hand, failing to reward often enough will result in customers failing to engage .

The late Xavier Dreze, Professor of Marketing at Wharton and UCLA explains, “The reward needs to come often enough so that there is reinforcement. At the same time, it can’t be too close. Then it wouldn’t be meaningful.”

Ensuring that members experience success when they go to redeem rewards is vital when it comes to reinforcement .

Research shows that successful reward redemptions encourage members to work harder to earn the next reward. “Once you succeed you think, ‘Hey, I enjoy this. Let’s do it again’” says Dreze.

Members who successfully attained a reward exhibited increased effort and drive in subsequent attempts to reach a goal

Dreze published findings in the Journal of Marketing Research with Joseph Nunes, Professor of Marketing at Marshall School of Business, University of Southern California, where they found that members who successfully attained a reward exhibited increased effort and drive in subsequent attempts to reach a goal.

Surprise and delight rewards (variable ratio reinforcement schedules) can result in huge boosts to loyalty and retention. This is also an effective strategy to deliver unpublished reinforcement to customers that may be half-way between elite-status-tiers as an effective barrier to switching, and may also spur customers to accelerate their spending to reach higher tiers.

BEHAVIORAL POTENTIAL

It’s easy to see how reinforcement can encourage repeat behavior — but how do we get potential customers to engage with our program in the first instance?

How can we get existing customers to engage in new behaviors?

A social learning theorist by the name of Julian Rotter developed a formula which can be used to predict behavior. The formula states that Behavioral Potential is a function of Expectancy & Reinforcement Value.

BP = f(E+RV)

Professor of Psychology Jack Mearns from California State University, Fullerton explains that “Behavior potential is the likelihood of engaging in a particular behavior in a specific situation.”

“The likelihood of a person exhibiting a particular behavior is a function of the probability that that behavior will lead to a given outcome and the desirability of that outcome”.

Applying the formula to loyalty programs, we can see that expectancy refers to a customer’s belief that:

  • they can complete the required goal; AND
  • that completing the goal will result in reinforcement.

An airline passenger may wish to earn a free flight, but if the requirement to earn the reward is too high then a “low expectancy” of reward will result in a lower likelihood of the desired behavior being undertaken.

Reinforcement Value refers to the desirability of the reward. An aspirational award such as a First Class Round-the-World trip would be highly desirable for many Frequent Flyer Program members. A toaster is unlikely to provide the same reinforcement value.

Rotter’s predictive formula can be used as a “sanity check” against the reward structure of your loyalty program.

To ensure that customers engage in the behaviors that you want them to first make sure that the rewards that you offer are both achievable AND desirable.

Karl Schuster, CEO of Virgin Australia’s Velocity Frequent Flyer program, recently commented that some programs “have forgotten that at the end of the day, it is about the consumer and their behavior and their emotions, and the fact they are in it to get a reward”.

Karen Zachary, Delta Skymiles Managing Director, agrees that customers join loyalty programs to get a reward. “From our perspective, why you join a loyalty program, is because you want a free seat sometime in the future”.

GOAL GRADIENT EFFECT

One of the most interesting areas of research is that of the Goal Gradient Effect, pioneered by Clark Hull back in 1932, which states that the tendency to approach a goal increases with proximity to the goal.

A study by Columbia University researchers studied the effects of the goal gradient effect in relation to real reward programs and found that memberspurchased more frequently the closer they were to earning a reward; and a stronger tendency to accelerate toward the goal predicts greater retention and faster reengagement in the program.

Dollard & Miller expanded on this with their research into approach-avoidance gradients.

People love approach gradients. They get excited as anticipated events draw closer.

Adjunct Professor Karrie Johnston from California State University, Fullerton explains that “we look forward to fun and exciting events such as birthdays and vacations, as we get closer to them we get even more excited. This excitement and anticipation translates into increased effort to reach the goal. That’s the effect of approach gradients. Avoidance gradients work the other way, the closer we get to having to sit an exam or visit the dentist, the more we dread having to do it”.

For loyalty programs, this means that as members get closer to achieving rewards, they will increase their effort to get across the line. This can translate into dedicating a higher-share-of-wallet to your airline or hotel, booking additional trips/stays that may have been discretionary, and engaging in additional co-brand and partner offers.

But if members perceive that the reward-goal remains far off — they are unlikely to display goal gradient behavior.

Linking the concepts of Dollard, Miller, Hull, Rotter, Skinner and other researchers —it is important to understand that as the distance to the reward (free flight, free hotel stay, status qualification) decreases, both the desirability and the expectancy of completion both increase.

ENDOWED PROGRESS EFFECT

Expanding further on this concept, Dreze and Nunes documented a phenomenon which they call the endowed progress effect.

Dreze and Nunes found that it wasn’t just the proximity to the goal that induced additional effort, but the perception of progress toward the goal.

In other words, as long as customers perceive that they are making progress toward a goal or reward, they will increase their efforts as a result.

The endowed progress effect demonstrated that reward program members that are given a “head-start” toward rewards, actually exhibit more effort and program engagement than members who start with zero progress.

Dreze and Nunes found that the psychology behind this phenomenon was related to the notion that people like to complete tasks that are already underway. Even if the “head-start” is illusionary, the fact that customers aren’t starting from zero — results in the shortening of the psychological distance to the goal.

Loyalty programs can implement endowed progress in a variety of ways to encourage greater retention and program engagement.

Some examples include:

  • Giving new members a “sign-up bonus” when they enroll in your program or complete their first flight/stay;
  • Giving elite-tier-members a “head-start” on elite requalification in subsequent years.

SUMMARY

The single most important takeaway for loyalty program managers is that your reward-proposition (“customer value proposition” in industry-speak) MUST be both attractive and achievable.

The reward proposition is what drives customer behavior

If customers perceive a reward proposition that is attractive and achievable, they will engage in the behaviors you request of them.

This may include flying/staying more often, spending more, and being a brand advocate and ambassador.

Ensure that the rewards you offer are compelling. Ensure that they are achievable. Ensure that you help your customers to engage in the desired behavior.

Lastly — successful redemptions are the “secret sauce” to profitable loyalty programs. Customers who successfully redeem are more likely to display greater retention and engagement in their pursuit of further goals.

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4 Responses to The Psychology of Loyalty Programs

  1. Michael Lowenstein August 6, 2016 at 8:21 am (1285 comments) #

    The thesis of this post is sound; however, as addressed a couple of years ago in response to a McKinsey analysis of loyalty programs, the bland, non-distinctive value proposition is where most of these initiatives are weakest:

    “A recent Forbes article by McKinsey (“Making Loyalty Pay: Six Lessons From The Innovators”), showed that, based on the consulting organization’s recent study, loyalty program participation has steadily increased over the past five years (a 10% annual rate of growth), with the average household now having almost 25 memberships (http://www.forbes.com/sites/mckinsey/2014/02/03/making-loyalty-pay-six-lessons-from-the-innovators/) For all of that growing popularity, there are huge questions for marketers: Are the programs contributing to increased sales? Are, beyond customers who would be loyal anyway, are they driving more purchase activity and narrowed consideration sets? And, what is the impact of loyalty programs on enterprise profitability?

    Overall, companies with loyalty programs have grown at about the same rate as companies without them; but there is variance in performance value among industries. These programs produce positive sales increases for hotels, for example, but negative sales impact on car rental, airlines and food retail. And, companies with higher loyalty program spend had lower margins than companies in the same sector which do not spend on high visibility loyalty program.”

  2. David Feldman August 6, 2016 at 9:17 am (2 comments) #

    Thanks for commenting Michael.

    I totally agree. The value proposition absolutely must be there, and differentiation is a key.

    The McKinsey article raises quite a few issues, and many of the recent high-profile program changes raise questions and risks about over-spending on customers that are going to purchase from you in any event, whilst under-investing on those with whom you can actually move the ‘spend-needle’.

    Thanks for your thoughts.

  3. Graham Hill August 7, 2016 at 7:07 am (992 comments) #

    Hi David

    Thanks for a well researched and informative article.

    I have been involved in restructuring a number of airline FFPs over the past few years. The effects you describe are the bread and butter of FFP economics.

    I am not sure where Michael L gets his data from, however there is a well documented loyalty effect for airline Frequent Flyer Programmes (FFPs), particularly on the highest-frequency, highest-value customers. For example, a study of SAS ticket pricing between 1992 and 2002 showed that its Eurobonus FFP introduced significant switching costs, particularly for business customers. The switching costs were equal to 12% of the average ticket price. Other studies show the switching costs to be equivalent to 12-18% of the average ticket price. The effect is sufficiently large that the Norwegian aviation regulator forbade SAS to use Eurobonus on Norwegian routes until the competitive intensity provided by the growth of Norwegian and other airlines was sufficient to compensate for the FFP effect. This restriction was only lifted recently

    Graham Hill
    @GrahamHill

  4. Tim Lavis business coach September 12, 2016 at 1:49 am (2 comments) #

    Loyalty programs are nowadays becoming all too frequent. Too many small businesses aren’t getting it right and missing out on opportunities. No doubt that loyalty programs are a great business strategy however they need to be executed correctly.

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