Prepaid's Breakage Windfall

  The financial windfall issuers are experiencing from unspent funds on their prepaid cards, called "breakage," may be gradually decreasing. Consumers, it appears, are becoming more savvy about gift cards.
  That is not likely to deter retailers from offering gift cards, however, because they make money on the merchandise spent and know gift cards draw both the buyer and the recipient into their stores. But it could have an impact on the less lucrative network-branded gift cards that banks offer.
  Research firm TowerGroup estimates consumers leave unspent $8 billion of the $80 billion they spend on gift cards each year.
  For instance, Best Buy last year recognized as income $43 million in funds remaining on gift cards unused for at least two years. Home Depot in December took $24 million in breakage for the first nine months of its fiscal year.
  But "the signs are that [those funds are] going to reduce greatly over time," says Brian Riley, a TowerGroup analyst. As they become more familiar with gift cards, consumers are more likely to ask for a receipt when using a gift card and track how much they've spent, helping ensure they use up all or most of a card's value, he says.
  And, as gift card spending has grown 20% annually in recent years, and growing numbers of consumers have complained about expiring cards or fees on idle cards, Riley says, state governments have begun to make it more difficult for issuers to claim unspent funds as revenue.
  Since late 2005, at least eight states have passed laws to protect consumers from losing money left on their gift cards, or to restrict issuers from charging fees on unused cards in order to drain the funds in those accounts, according to advocacy group Consumers Union, publisher of Consumer Reports.
  For example, some states, such as New Jersey, decided that gift cards issued in their state can never expire, Riley says, and Ohio will not allow issuers to charge any fees for the first two years after a card is issued. About three dozen states now have laws that address unspent funds in some way, Riley says.
  However, a Best Buy spokesperson says the company did not violate any laws, since the cards never expire and no fees were charged. The company simply made an accounting change, moving the funds from the liability to asset side of the ledger. A consumer with an old card still could redeem it.
  However, the federal government has begun to put pressure on merchants that charge maintenance or other fees. In March, Kmart agreed to implement a refund program to settle Federal Trade Commission charges that it engaged in deceptive practices in advertising and selling its gift card. The FTC argued in its complaint that Kmart promoted the card as equivalent to cash but failed to disclose that fees are assessed after two years of nonuse. Kmart also misrepresented that the card would never expires, according to the complaint.
  Under the settlement proposal, Kmart will not sell its gift card without clearly disclosing fees in advertising and on the front of the card.
  The FTC filed a similar complaint against Orlando-based Darden Restaurants Inc., according to a company filing with the U.S. Securities and Exchange Commission.
  The FTC's actions have put gift card issuers on notice that the government may require more disclosure of fees, and perhaps even sending out detailed statements.
  Studies show that consumers who receive a store gift card go to the store more often and spend more than they would otherwise, Riley says.
  That is Best Buy's experience, the company spokesperson says. For each dollar the company spends on gift cards, it figures to get two dollars in return.
  Bankers, though, are primarily interested in prepaid products that build up deposits, such as payroll cards, says consultant Steve Mott of Stamford, Conn.-based BetterBuyDesign.
  Most banks consider a gift card program "more trouble than it's worth," Mott adds. "A lot just do it as a service for their customers, especially around the holidays." Most bank-issued gift cards carry network brands, mostly Visa or MasterCard.
  In 2005, Mott says he was hired by a large regional bank to evaluate its network-branded gift card program. He found it was generating an 11% profit, a level consistent with most bank gift cards. By comparison, he says, payroll cards typically generate a 30% to 40% profit. If gift card breakage, which Mott estimates at about 5% to 7% of card value, shrinks, many banks may jettison those programs.
  Some already have. Bank of America stopped selling consumers its general-purpose, Visa-branded card two years ago, although it continues to offer cards for corporate clients. The regional bank that hired Mott, which he would not name, also canceled its gift card program.
  But Paul Tomasofsky of Montvale, N.J.-based Two Sparrows Consulting, takes the view that banks may benefit overall if consumers do spend more of the funds on their gift cards. Less breakage means consumers have learned to take full advantage of gift cards, which might increase demand. That would boost transaction volume and the income the issuer receives from interchange.
  Another benefit, Tomasofsky notes, is that consumers would complain less about losing the funds on their gift cards. And that could cause state legislators to lose interest in imposing new restrictions on issuers.
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