Loyalty programs, which give consumers rewards for repeat purchases from particular merchants, are almost as common among retailers as cash registers. McKinsey research found that about half of the ten largest US retailers in each of seven sectors have launched such programs, and the rate is similar among top UK retailers. Moreover, loyalty programs are popular with customers: in the United States, 53 percent of grocery customers are enrolled in them, to say nothing of 21 percent of the customers of casual-apparel retailers. Of those who join grocery programs, McKinsey research indicates that 48 percent spend more than they would otherwise, though the figure is only 18 percent in casual-apparel programs. Yet even 18 percent represents a sizable number.

If anything, we expect interest in loyalty programs to intensify. Faced with slowing revenue growth in many categories and the emergence of competing Internet start-ups, retailers are eager to deepen their relationships with existing customers and to increase their share of wallet. Retailers that have stand-alone loyalty programs—in other words, programs without corporate partners—must work out ways of dealing with alliance programs, which bring groups of retailers together to offer rich rewards as well as rebates beyond the reach of most individual retailers.

But retailers are reluctant to face some serious questions. Is heavy investment in loyalty programs likely to make a difference in the behavior of customers? Do they really value these programs? Are any retailers getting their money's worth? The answers are not straightforward. Many loyalty programs are successful; they enhance the value propositions of retailers, capture valuable data, draw in higher-profit customers, and persuade those customers to spend more. But as many or more programs unwittingly deploy value-destroying mass-discount vehicles, and the problem is likely to worsen as retailers respond to sluggish growth. Every such retailer would do well to consider some hard facts about the real profitability of most programs, the economic traps behind the numbers, and what it takes to ensure success.

The trouble with loyalty

Many loyalty programs struggle with three stubborn facts.

First, the programs are expensive. Our research revealed that 16 major European retailers had a total of some $1.2 billion tied up in annual discounts to customers, with several supermarket chains devoting some $150 million. Costs are about the same in the United States. Given large sales volumes, even programs with modest rebates (up to 1 percent) can cost a great deal of money. Then come the costs of marketing and managing a program—investment in systems, fulfillment support, and so forth—which usually run well into the millions.

Second, loyalty programs take on a life of their own once they start, so mistakes can be very difficult to correct. Even programs with low benefits become entrenched in the minds of customers, who must be informed when they change or come to an end. Customers react negatively to any perceived "take away" once a program is in place, even if they are not actively involved in it. Curiously, the successful launch of a program worsens the problems of ending it. And a negative experience with a program heightens the skepticism of consumers when they are offered a follow-up program and can undermine their trust in a retailer more broadly.

Third, these programs, despite their number and apparent popularity with customers, often fail to increase customers' loyalty. In fact, 79 percent of customers in casual apparel and 70 percent in grocery say they are always seeking alternatives to their current retailers—percentages that far exceed the percentage of customers actively seeking alternatives in other categories. Nor do consumers who join a loyalty program necessarily increase their spending.