Retainage in Construction: The Comprehensive Guide
Blog Credit: Andy Morris, April 21, 2021 (Retainage in Construction: The Comprehensive Guide | NetSuite)
One of the distinctive aspects of the construction industry is that for many projects, contractors know going in that they aren’t getting paid in full until the work is completed. Welcome to the practice called retainage, which allows a project owner to hold off on paying the full price until the project is “substantially complete” and signed off on. To ensure they’re ultimately paid all monies held back, construction contractors need a thorough understanding of the details of retainage, why it exists, how it affects owners, contractors, subcontractors and suppliers, and the ways its impact can be managed.
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What Is Retainage?
Retainage is the withholding of a portion of the final payment for a defined period to assure a contractor or subcontractor has finished a construction project completely and correctly. Retainage, a standard practice in both public and private projects, functions as a financial incentive and guarantees that the project is completed to the owner’s satisfaction. The amount held back is typically defined in the contract, and usually ranges between 5% and 10% but can sometimes be higher.
Retainage vs. retention: What’s the difference?
These two terms are often used interchangeably, but in certain cases the terms retainage and retention have different meanings. In construction, retainage may refer to the amount being held back, and retention could indicate the act of withholding the money.
- Retainage percentages and payment structures are set forth in construction contracts and can change by project.
- Retainage often limits a contractor and subcontractor’s cash flow and may lead to abusive financial tactics.
- Government regulations on retainage vary by state and whether a project is public or private.
- Other options such as bonds or separate security can be used as well, but retainage still remains one of the most effective ways to ensure a job is correctly completed.
- Financial management software can help businesses better manage their retainage receivables and payables.
The idea behind retainage is to create financial incentive for contractors to complete the project and offer protection for owners should problems arise during construction or for a specified amount of time after completion. Also, since profit margins in construction often are low, the standard retainage of 5% to 10% usually winds up being the contractor’s profit. Thus, retainage encourages timely and appropriate completion.
Details of retainage must be spelled out in the contract between owner and contractor, as well as between the contractor and subcontractors. States vary in their regulations of retainage. Some states are specific, some are vague and some have no regulations at all. It’s important to determine the specific rules in the states where a contractor works.
If retainage details are not spelled out specifically in a contract, then there is no retainage.
How Does Retainage Work?
The payment schedule and the percentage of money to be withheld is detailed in the contract between parties. Typically, that retainage amount is taken out of each progress payment. For example, if a project calls for 10 payments of $20,000 each and a 10% retainage was negotiated, then the owner would pay $18,000 each time. The remaining $20,000 in retainage gets released upon completion of the construction project or a specified period after completion, depending on the terms of the contract.
Retainage from individual installments may not necessarily represent much hardship during the construction process. But over the course of the project, that money adds up to a strong incentive for a contractor to finish the job. When the retainage terms are met, the money is released and paid to the contractor, who then must pay withheld money to subcontractors.
Sometimes, retainage may be determined based on the stage of the project, where the percentages vary depending on construction benchmarks. The details and percentage of retainage can vary from job to job and from state to state for public projects.
State regulations governing holding time of retainage vary for both public and private jobs. For example, in California, retainage on private projects must be released within 45 days of “date of completion.” The contractor then has 10 days to pay retainage to subcontractors. In New York, retainage must be released within 30 days after “final approval of the work,” with subcontractors needing to receive their withheld funds within seven days.
Note the two states’ selection of words, which indicate two different concepts: date of completion versus buyer approval. It’s not uncommon for opinions to differ on what constitutes completion of a job.
Why Is Retainage Important?
Retainage is meant to encourage productivity and efficiency. It provides financial incentive for a contractor to finish the job and do it well. Many consider it the most effective insurance policy an owner has over contractors, and contractors over subcontractors and suppliers.
Retainage may be most important in the last stages of a project. If a contractor were to have received all progress payments in full, that contractor may decide it’s a better play financially to move on to the next project should problems or a dispute with the project owner arise. For the owner, retainage provides funds should a contractor or subcontractor default on the job. If a contractor can’t complete the work agreed on for any reason (e.g., lawsuit, fraud or frozen assets), the funds held in retainage can be used to pay subcontractors or another contractor to finish the job.
But for contractors, retainage can lead to cash flow concerns. As they wait to receive their full fees for one project, they still must pay their employees their full wages, make insurance payments, buy supplies and equipment and finance new projects. Overcoming cash flow concerns can be a major hurdle, especially for small businesses. And tight cash flow can lead to tensions in business relationships and dealings.
History of Retainage
Retainage began in the United Kingdom in the 1840s during the boom in railroad construction often referred to as “railway mania.” As the speculation bubble of railroad investment grew across the U.K., so too did construction and the creation of new companies, each competing in a largely new and unregulated industrial sector. This elevated the demand for contractors in the mid-19th century labor market. Many of the people who filled the void lacked necessary experience, qualifications and skill sets to complete their jobs properly. Such subpar craftsmanship forced railroad companies to begin withholding as much as 20% of the payments due contractors to ensure work was done properly and effectively.
If they leave without warning, having to unexpectedly replace contractors and other workers was time-consuming and expensive. Retainage helped guard against those costs. Retainage sought to hold back the profit portion of the money for the contractor, rather than put the investor’s money at risk, thereby incentivizing proper execution of the project.
Purpose of Retainage
Retainage, also referred to as a “hold back,” helps the owner ensure a contractor sufficiently completes the project, and that the work meets with their approval and terms of the contract. It also provides a financial incentive for the contractor to see the project through to its successful finish. Withheld funds act as a safeguard for everyone involved in the project, from the owner on down through subcontractors and suppliers.
What Are the Rules of Retainage?
The agreed-on terms of a construction contract dictate the specifics of retainage, such as percentage withheld, how much is withheld with each payment and when the funds can be released. Keep in mind, most states have set some legal limitations. Those limits may differ if it is a federal project, a state or county project or a private project. It’s best to know the specific retainage rules of the state you will be working in before signing the contract.
On federal projects, as much as 10% can be held back by the project owner “until satisfactory progress is achieved,” according to the Federal Acquisition Regulation. In practice, though, it often scales lower and includes gradual reduction as construction benchmarks are reached. A contractor also may use retainage with subcontractors, even if the government is not doing so with them. However, in these cases, that contractor can’t bill the government for the withheld money. This, in effect, creates an unofficial retainage by the government.
When it comes to state, county and municipal projects, some states actually require retainage while others set limitations. In some states, withheld funds are defined as a percentage of the total contract price, not of each payment. So, depending on how the payment plan is structured, a project could reach the maximum retainage amount early and then not have any other funds held back in the final payments. There are states where the common practice is that retainage ends after 50% project completion.
Some states cap retainage as 5% on public projects, whereas others use 10%. Retainage limitations on private projects would vary by state.
Who Should Use Retainage?
Many in the construction industry may not want to use retainage, yet it remains one of the best way to secure substantial completion of a project and protect the owner in case a contractor defaults on the job. That’s why project owners typically use retainage, especially for large projects. It’s an extra level of insurance for them. Contractors who have money withheld by the project owner should also use retainage with their subcontractors to mirror the protection that the owner has established. Passing retainage down the line helps contractors better manage cash flow and incentivizes subcontractors to complete their portions of the job. Other best practices for construction accounting can help contractors and subcontractors reduce the burden of held back funds.
Who Benefits From Retainage & How?
Retainage affects the entire construction chain. And while the notion of withholding money may seem unfair, the process of retainage does offer benefits, even for contractors and others involved in the project.
- Owners: The project owner benefits by an incentive for contractors to complete the job properly. An owner also can use withheld money to complete the job if a contractor defaults. Another way the owner can potentially benefit is by earning interest on the retainage, depending on the terms of the contract.
- Contractors: Similar to an owner, contractors also benefit by having leverage over the subcontractors to complete their parts of the job. Contractors also could earn interest on subcontractors’ retainage if the contract allows for it.
- Subcontractors: Subcontractors benefit indirectly by feeling incentivized to do the job completely and properly. Plus, if a contractor fails to meet their obligations, subcontractors can receive their retainage from the owner.
- Banks and insurance companies: Retainage on a project offers these entities more security in the job getting done correctly and within budget, lowering their risks in lending or insuring the project.
Impact of Retainage on Contractors, Subcontractors and Material Suppliers
When a contractor begins a project with retainage attached, they know they’re not collecting 100% of the contracted amount right away. That makes an impact on how companies manage their finances and working relationships.
- Contractors: With profit margins being low in construction, there can be times when the retainage percentage is greater than the projected profit. Lengthy disputes about completion where there is any ambiguity can exacerbate those cash flow concerns, and if the disagreement requires legal action, it can become an even more costly burden for contractors. In such cases, a contractor may feel cash-strapped for this and other projects, and sometimes compensate for it by withholding a higher percentage on subcontractors. This can damage valuable relationships with subcontractors, or even make it difficult to find workers willing to operate with such a high retainage percentage.
- Subcontractors: Subcontractors often feel the biggest brunt of retainage. For example, they may complete their portion of the work in the first month, then have to wait another 10 months for the entire project to finish before they’re paid in full. Meanwhile, in those 10 months, they still have to make 100% of their payroll and other costs of doing business on anywhere from 90% to 95% of earned revenue.
- Material suppliers: They possess little to no leverage on the retainage front. They may float all their costs at the outset and often have to wait the longest to receive full pay. The more hiccups in the construction project, the longer it takes for suppliers to recoup owed money for supplies already purchased, delivered and installed.
Arguments Against Retainage
While retainage has its pros, it also has its share of controversy and negative feelings. After all, when you complete a job, you want to be properly and fully compensated in a timely fashion. Retainage can get in the way of that payment. And depending on when your work was done on the project, you may disproportionately feel those effects.
- Retainage may exacerbate existing cash flow problems. Many construction businesses often lay out the full costs and expenses of projects up front, then hope to get paid along the way. That puts them in a cash-flow bind. Adding retainage to that only tightens the vice.
- It takes too long to collect. Even when getting paid on a regular schedule, the contractor still has to wait to be paid in full. The time frame for retainage release varies by state, and even then, there can be debate about whether a job is completed to the satisfaction of the parties. This can have a worse effect on a subcontractor, particularly those who complete their work in the early stages of the project and must wait until the entire job is done to collect.
- It sows mistrust. Are contractors withholding funds from subcontractors at a higher rate than what the owner is doing to them? If suspicion sets in, productivity and quality can suffer, which in turn can affect full release of monies owed.
Retainage may be fixed or variable, depending on the terms of the contract. With a fixed percentage, typically in the 5% to 10% range, the same percentage of the total amount due is held back from each payment. With variable retainage, the percentage can change based on the stage of project completion. For example, a 10% retainage could drop to 5% after a project is considered halfway done.
The construction industry has an unusual payment process. Instead of sending an invoice, contractors use what’s called a payment application (aka pay application, an application for payment or a pay app). These go beyond a simple invoice. They typically include progress reports of the completed work and materials delivered, subcontractor invoices, schedules of work still to be done, photos and payroll receipts, among other documents.
When retainage is held back in each progress payment, the contractor must account for it in each pay app. This can be done by billing for the full amount of that payment, less the retainage and showing the new number in the final billing total.
For example, say you’re billing a client for a $20,000 initial payment on a $100,000 job and the contract calls for 10% retainage. Your payment application would show $100,000 as the original contract amount, followed by a line indicating a payment due of $20,000. Then a line would deduct the retainage — in this example, $2,000 (10% of $20,000). The final total for this payment application is $18,000.
Each job may have its own set of unique requirements, making the process more complex. The American Institute of Architects (AIA) and the ConsensusDOCs group each offer standardized pay app templates that can help boost your efficiency. And financial management software can help you track and manage these payments to make sure you’re not missing out on much-needed funds.
Advantages and Disadvantages of Retainage
Where you land in the construction supply chain helps shape the pluses and minuses of retainage. Here’s a look at the pros and cons.
- It works. Retainage has been practiced for more than 150 years for good reason. It remains perhaps the most effective way to ensure satisfactory completion of a construction project.
- It offers financial incentive for quality work. All businesses want to be properly compensated for their work. Withholding a few percentage points of the agreed-on price with each payment adds up over the course of a project, and is a way to ensure work is done well and on time by contractors and subcontractors.
- It provides a built-in remedy. Should a contractor fail to complete a project, the money held in retainage gives the owner a source of funding to pay subcontractors and suppliers to complete the work.
- It can cause financial hardships. Construction is a complex business with many different types of workers involved — including owners, contractors, subcontractors, sub-subcontractors, suppliers and labor workers. What subcontractors may consider completion of their projects, contractors may see as one part of the puzzle. And if the owner waits for the puzzle to be completed, retainage money is not paid out. And when it is paid, it goes to the contractor, who then pays subcontractors and suppliers. In particular, this can more adversely affect a subcontractor whose work was an early part of the project as opposed to those in the later stages.
- It can be abused. Construction contracts, as well as regulations in some states, specify how long the parties can hold on to the retainage funds. Some will hold onto it until the last possible day, simply because they can. In some instances, there may be disagreements of what constitutes a job well done. Some contractors hold back a greater percentage to subcontractors than what the owner withholds from them. If contractors choose to not pass down retainage for subcontractors, the subcontractors have to pay out of pocket, adding to their financial risk.
Four Steps to Eliminate Retainage
Retainage may be looked at by some as an outdated practice, yet it remains in place and is viewed by many as a necessary evil of the construction business. Still, there are ways to potentially eliminate it or at least mitigate its negative effects.
- Use retention or surety bonds. In place of retainage, a construction contractor pays the premiums of a surety or retention bond. The customer of that contractor is the beneficiary. In a way, this acts like reverse retainage. But the difference is that the contractor receives full payment along the way. The owner still has the opportunity to put in a claim against the retention bond if something with the project goes awry. Ideally, you’d want the bond premium to be less than the retainage would have been in order for this to make the most business sense.
- Allow substitute security. An owner may allow a contractor to supply another form of security to help protect their investment, such as a bank letter of credit or a form of U.S.-guaranteed securities, such as bills, certificates or notes.
- Set up a construction trust fund. Many states have enacted construction trust fund statutes. In this scenario, money received by a contractor for payment of subcontractors is held in an interest-bearing trust account. A contractor can’t use those funds until everyone gets paid what they are owed. A contractor who uses those funds improperly can be held liable, and subcontractors have the right to sue for their payments.
- Put retainage in an escrow account. By putting the withholdings from progress payments into an escrow account, a contractor could earn interest on it and use that interest earned to pay down-the-chain expenses and retainage. It also could help with cash flow. These details would need to be spelled out in the contract.
- Build a good reputation. It can’t hurt to ask, right? If contractors have solid reputations and a history of success, they can sometimes negotiate the percentage down or ask for decreasing retainage percentages as the project passes certain milestones.
Statutes of Retainage
Every state has different regulations governing how owners and contractors can use retainage. Those statutes may cover the maximum percentage allowed, how funds are stored (an interest-bearing escrow account, for example) and amount of time funds can be withheld. Within those parameters, there can be even more nuance within a state.
For example, in Illinois, private projects have a 10% maximum retainage amount, but it drops to 5% when half of the project has been completed. But this doesn’t apply to residential projects of 12 or fewer units.
No matter your role in the construction project, it’s worth being familiar with the regulations in your state. That includes the time frame for filing a mechanic’s lien, which are documents you file so you can seek unpaid compensation. Often, the deadline for filing such a claim expires before retainage is due, and the laws on this are unclear in most cases. Yes, you have the right to file a lien against a contractor or owner for withheld money, but that deadline could pass before the contractor or owner has any legal obligation to pay retainage.
Some states have started to address this. New York changed its lien laws to allow a claim to be filed up to 90 days after retainage was due. Before that, it was up to 90 days after completion of the work.
How Software Helps With Retainage
There’s no substitute for efficiency in business. And with the uniqueness of the construction industry, contractors need management software that best optimizes their administrative and accounting work. From digital invoicing to invoice approvals, and lien management to paying retainage, cloud-based financial management software can help construction businesses of all sizes. It can automate invoicing, with specific line items for retainage in both directions (accounts receivable retainage and accounts payable retainage).
Financial management software also allows contractors to standardize their forms across all projects, increasing efficiency. It helps pay subcontractors quicker as well, thus reducing errors and risk. The more efficient you are with your accounting and paperwork, the more you can dedicate company resources to the value-added and client-focused parts of the business.
Many in the construction industry consider retainage an unavoidable evil of doing business. But it remains an effective way to ensure a project is completed and done well. Owners of large projects consider retainage a key financial safeguard that lets them pay someone else to finish the job in the event the initial contractor or a subcontractor defaults. States have enacted regulations limiting retainage percentages and abuses, but those laws vary. It’s best to learn about the rules in the state or states where you do business. And advanced financial management software can help you navigate the nuances of retainage, including invoicing and managing complex retention structures.
Retainage is the holding back of a certain amount of money paid to contractors and subcontractors to ensure a project is completed and done well. This withholding typically ranges from 5% to 10% of the full project cost. The project owner withholds retainage from the contractor, who in turn withholds it from subcontractors, who in turn withhold it from sub-subcontractors and suppliers.
The agreed-on percentage of retainage is typically deducted from each progress payment. Certain states require the full retainage be withheld early in the project, either by a specific payment number or by project completion milestones.
The terms “retention” and “retainage” mostly are used interchangeably. But in certain instances, “retainage” refers to the money being held back and “retention” to the act of withholding the money.
The line items for retainage on an invoice show the amounts the project owner is supposed to withhold when paying the invoice. Different invoice line items may indicate how much money has been withheld for various categories (labor, materials) and how much was paid out in a particular progress payment.
Who holds funds considered in retainage depends on the details of a construction contract. Retainage money can be held in an escrow account, a trust fund account or another separate account.
A contractor can hold back its retainage from subcontractors until the project is deemed “substantially complete” and the owner releases its retainage money to the contractor. Each state regulates that time differently, so it pays to know the specific laws in your state. Subcontractors also have the right to file a mechanic’s lien to seek payments, but the deadline for that might conflict with the retainage deadline, depending on each state’s rules.
A project’s retainage percentage typically is between 5% and 10%. Some states have set limitations on how much can be withheld, and that can vary depending on whether it’s a public project or a private project.
If a project that pays $250,000 has 10% retainage, for accounting purposes that means $225,000 is considered accounts receivable and the remaining $25,000 is the retainage. Progress payments should indicate how much is being withheld each time. Good financial management software for projects will have line items to enter for retainage to help construction businesses manage receivables and payables.