Retainage: How It Works and Best Practices

In the high-stakes world of construction finance, there are various arrangements and payment mechanisms that are specific to the industry. One payment mechanism is retainage.

In this article, we will delve into the the purpose of retainage in construction projects, highlighting benefits, drawbacks and best practices.

What is retainage?

Retainage — or retention or holdback — is a common practice in the construction industry where a portion of payment, typically 5-10%, is withheld until a predefined milestone is achieved on a building project. Retainage has a long history in the industry and can apply to both general and subcontractors.

The Purpose of Retainage

Retainage, when properly utilized, is designed to address several issues inherent to construction projects:

• Quality assurance: Retainage incentivizes the general contractor, along with any applicable subcontractors, to complete work to the satisfaction of the owner. It also encourages contractors to meet or exceed quality and performance standards on a project.
• Defect correction: By withholding a portion of payments, retention provides the owner or general contractor with financial leverage. This leverage ensures the contractor addresses any defects, deficiencies or incomplete work.
• Project completion: Retainage motivates contractors to complete their work within the agreed-upon schedule to avoid abandoning or leaving projects unfinished.

Benefits of Retainage

Retainage offers several benefits for both owners and contractors.

• Risk mitigation: Retainage helps mitigate the financial risks associated with contractor and subcontractor defaults, delays and/or incomplete or defective work.
• Quality control: As a practice retainage encourages contractors to maintain a high quality of work throughout a project, as the release of the retained pay can be contingent on meeting specific project standards.
• Dispute resolution: Retainage provides a financial cushion for owners to address disputes, deficiencies or disagreements that may arise during a project.
• Cost mitigation: For contractors and subcontractors, agreeing to retainage prior to engaging on a project often means an owner will not require a performance bond or other financial guarantee. This can result in significant cost savings.

Drawbacks and Challenges

While retainage has advantages, the practice is not without its challenges.

• Cash Flow Impact: In an industry already often beset by thin margins and cash flow issues, retainage can create further financial strain on the bottom line of contractors and subcontractors.
• Administrative Burden: Holding retainage on payments to contractors and subcontractors creates bookkeeping and administrative burdens for all parties involved. Critics commonly cite complex accounting and escrow issues as criticisms of the practice.
• Delayed Payment and Abuse: There is some complaint across the industry that retainage can result in unnecessarily delayed payment and — in extreme cases — abuse. For example, in the 2018 case United Riggers & Erectors v. Coast Iron & Steel, the California Supreme Court ruled that retainage payments could only be withheld if a dispute was in good faith. And, in that particular case, the general contractor at issue had not offered any justifiable reason for holding back retainage payments to its subcontractor.

Best Practices

As with so many things across the industry, it all comes back to the contract — meaning either the prime contract between the owner and general contractor or the contract negotiated between the general contractor and a subcontractor.

Negotiate

The first and most important thing to make clear is that in a majority of jurisdictions, retainage is negotiable. This implies that before beginning a project, both the owner and the general contractor, or the general contractor and subcontractor, must agree on the amount of money retained, or even if any money will be retained at all. For example, an owner and contractor might agree to retain 10% of the payments until the job reaches 50% completion, after which they will reduce the retainage on progress payments to 5%.

Once parties agree on the use and amount of retainage, owners, general contractors, and subcontractors should next agree on where to hold the retained payments

Keep Relationships and Reputation

When negotiating retainage on a project, two factors are essential: Past performance and the parties’ relationship. If a contractor or subcontractor has a long history in the industry of meeting owners’ expectations and performing quality work, that contractor might argue for less (or no) retainage on payments.

Likewise, if an owner, contractor and/or subcontractor have a prior relationship — say, they’ve worked together on projects in the past, to the satisfaction of all parties involved — then that contractor or sub may also make a case for lesser or zero retainage.

Finally, when parties have agreed to retainage, it is vital that general and subcontractors plan for less upfront income throughout the project. Though retained monies will eventually be released, a cash crunch will likely be felt in the short term.

The Origins

According to the Department for Business, Energy & Industrial Strategy for the United Kingdom, the practice of retaining a portion of payment on building projects began in the 1840s, during the country’s rapid expansion of its railway industry. The sector’s boom led to hundreds of new construction companies entering the market to capitalize on the opportunity.

However, many of these inexperienced companies were unable to work to the required standards, which led to a high number of insolvencies. As a result, railway companies in the U.K. began to withhold 20% of contractors’ payments as security to ensure a project’s completion.

Legal Limits

Some jurisdictions set limits on the amount of money that may be retained on payments, how that money must be held, and which types of projects are allowed to use retention in the first place.

To explore the laws around retainage in the United States, see Levelset's interactive map: Retainage Rules Across the United States.

However, the most important thing governing the use of retainage on a project is always going to be the contract between the owner and the general contractor, or that between the contractor and the subcontractor.

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Alternatives to Retainage

There are two main alternatives owners or general contractors typically request in lieu of holding retainage on a construction contract. They are a performance bond and a letter of credit.

Performance Bond

A performance bond guarantees that a contractor or subcontractor will complete the work outlined in a construction contract, and a surety company issues this type of bond. If a contractor or subcontractor fails to complete the work as agreed, the owner or general contractor can approach the surety company for compensation.

The second request an owner or general contractor may make in exchange for foregoing retention is a letter of credit. A letter of credit provides a financial guarantee from a bank or other financial institution to pay a certain amount upon request. If the contractor or subcontractor fails to perform the work as specified, the owner or general contractor will make this request, making the contractor or subcontractor liable for the amount.

Retainage Bond

A retention bond is an agreement stating that in exchange for not withholding cash retention, a construction business will pay the premiums of a bond that takes the place of retainage funds. With retention bonds, the customer of the party who submits the bond is the beneficiary of the bond. This means that if there’s an issue with the work of the party who’s paying the bond premium, their customer can claim the bond to pay for it.

Unpaid Retainage

Finally, a contractor or subcontractor eligible to file a mechanic's lien when their retention remains unpaid, as retainage represents a portion of money due for improvements to real property. A mechanic's lien is a legal claim on a home or other property, giving an unpaid contractor an interest in the property itself.

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