Frequent Flyer Program Myths and Realities

Travelers have plenty to worry about these days: bankrupt carriers, surly service from demoralized customer-service employees, shrinking legroom, flight disruptions caused by labor walk-outs, and a flurry of fees.

For those who make earning miles a priority, another gnawing concern is that the airlines will summarily terminate their mileage programs in order to escape the costs of operating the programs and the liability of millions of free award tickets.

The probability that an airline will abandon its mileage program has everything to do with revenues and costs. But unlike the financial performances of the airlines themselves, which are widely disclosed and reported, frequent flyer program accounting remains a mystery to all but a few bookkeeping-minded analysts. The reason is that airlines typically fold key revenue and cost figures for the programs into the results for the company overall and bury other program-related stats in the footnotes of their annual reports.

Two recently published papers from IdeaWorks, a consulting company specializing in the travel industry, shine some light into these dark corners of airline financial performance. The findings, summarized below, deflate several myths surrounding the programs’ inner workings and underscore just how central the programs have become to the health and welfare of the world’s largest airlines. And most importantly, they should put to rest any worries that airlines will voluntarily take mileage programs off the table.

(For those so inclined, the papers are available online.)

Myth 1: Airline frequent flyer programs are principally loyalty programs, part of the carriers’ overall marketing efforts to convince the traveling public to buy more tickets.

Reality: When American Airlines launched the first modern mileage program, AAdvantage, in 1981, the goal was indeed to recognize and reward loyalty, thereby boosting ticket sales.

But as the programs succeeded and grew, they evolved into different animals. They became revenue-generators, profit centers, and big businesses unto themselves.

American’s AAdvantage program now boasts more than 1,200 partners—hotel chains, rental car companies, credit card issuers, telecom services, finance companies, and retailers—which offer consumers AAdvantage miles if they buy their products or services. Each of those partners must purchase the miles from American at a rate of between one and two cents per mile.

Those pennies add up to approximately $1 billion in annual revenues for American. For the U.S. airlines as a group, total revenue from the sale of frequent flyer miles is estimated at $12 billion per year.

Myth 2: Due to the number of award tickets distributed to program members, frequent flyer programs are very expensive to maintain.

Reality: Because the airlines rarely give away a seat that otherwise would have been sold, the real cost of frequent flyer awards is the out-of-pocket expense to fly one additional passenger, such as jet fuel, an in-flight meal (if any), and insurance.

According to the airlines’ own internal accounting, those costs range between $10 and $20 per award.

In other words, the airlines can offer an incentive valued at $300 or more by consumers for a real cost to the carrier that is closer to $15. That, in a nutshell, is the leverage that makes mileage programs as attractive as they are to the airlines.

Myth 3: If all frequent flyer program members decided to cash in their miles for awards, the flood of non-paying passengers would overwhelm the airlines and drive them into bankruptcy or worse.

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Reality: First, the airlines’ highly sophisticated inventory-management systems ensure that no matter how intense the demand for awards might become, only a very few seats on any flight will be available for use by award travelers. Realistically, there’s no danger of the airlines drowning in a flood of redemptions.

But the question of award liability—how many free tickets are represented by all those outstanding miles—is still an intriguing one.

According to Sorensen’s analysis, at the end of 2004, the 11 largest U.S. carriers had outstanding miles redeemable for 49 million award trips. In dollar terms, the airlines’ current award liability amounts to approximately $3.5 billion.

Myth 4: Over the long term, most frequent flyer miles are redeemed for awards.

Reality: Yet another of the industry’s dirty little secrets is spoilage or breakage—the percentage of miles that simply disappear into the ether. Miles go unredeemed for a number of reasons: they expire, they never add up to an award, or their owners die. From the airlines’ standpoint, breakage is a good thing because it results in fewer claims for award tickets. From a consumer standpoint, it’s a red flag: A high percentage of unused miles may indicate that it’s particularly difficult to obtain awards in a particular program.

Of the airlines under Sorensen’s microscope, only seven reported their spoilage rates. At the low end was Alaska Airlines, with 12 percent of its members’ miles remaining unredeemed. At the high end was JetBlue, with 70 percent of its points unused (owing at least in part, one assumes, to the airline’s policy of expiring points after just 12 months). Of the largest airlines for which breakage figures are available, United was lowest at 17.6 percent; Delta was highest at 46.7 percent.

Myth 5: The airlines are ambivalent about their programs and would be happy to discontinue them if other carriers would do the same.

Reality: This may be true of smaller carriers and discount airlines, which have not built out their programs to become significant revenue-generators.

But the largest airlines, which operate the largest programs, are making significant profits from the sale of frequent flyer miles. As long as the programs remain profitable, it would be downright self-destructive to terminate them.

Myth 6: Year over year, award travel is increasing.

Reality: Given that airlines are constantly increasing the opportunities for program members to earn miles—more partners, more promotions—it would be natural to assume that the number of free tickets issued would be increasing commensurately. More miles earned means more miles redeemed for awards, right?

In fact, Sorensen estimates that for the 14 airlines covered, award travel actually decreased by 2.1 percent from 2003 to 2004, from 15 million to 14.7 million trips. That’s in spite of an 8.4 percent increase in capacity. The conclusion: “It should not be surprising that the industry has sought to sell every seat it can—even those that once were saved for frequent flyer award travel.”

The take-away

With their enormous revenues and relatively miniscule costs, the large mileage programs are very profitable enterprises.

That’s good news for consumers. It means that mileage programs will remain a fixture on the travel scene for the foreseeable future. And it also suggests that the airlines are, and will continue to be, under pressure of the direst sort to keep their programs robust and value-packed: the pressure to survive.