The construction sector is unique in many ways. Construction parties have lien rights, for example, which allow them to secure payment from delinquent clients. Not all industries protect their stakeholders from non-payment, which goes to show how often payment conflicts arise in the construction business.
Retainage is another unique feature of construction. Unlike a mechanics lien, however, retainage is a controversial topic among construction participants. Not all contractors, subcontractors, and material suppliers are keen about retainage, although it remains to be widely used across all 50 states.
This article will walk you through the basics of retainage in construction, what it seeks to do, and how it affects different construction stakeholders.
What is retainage in construction?
Retainage is essentially the practice of withholding payment from construction parties until a construction project is “substantially finished.”
The paying party – typically a property owner, general contractor, or government entity – keeps a certain percentage of the contract amount to themselves, effectively paying a lower amount to a lower-tier contractor or materialman and only releasing the full payment when a project has wrapped up.
Retainage is practiced in both private and public construction projects. Private owners and federal offices have been practicing retainage for the past century, and each state has its own rules and requirements regarding its use.
As mentioned, retainage continues to be a tricky topic in construction. While owners and general contractors are generally in favor of withholding funds until the very last day of the project, subcontractors and other lower-tier parties are not so keen about not receiving their full payment as they work on a property.
Purpose of retainage
This is an important question: What, indeed, is the point of keeping payment from construction parties who have been rendering work on a project?
When the practice of retainage started in Europe in the 1800s, its purpose was to encourage contractors to perform their job properly all the way until the end of the project. On top of that, retainage also sought to protect property owners in cases of contractor delinquency.
The idea is that contractors would be more diligent in sticking to the contract schedule and making sure that everything was done properly if their full payment would only be released on the final day of the project.
Property owners will also have a financial cushion in case a contractor or a material supplier fails to fulfill their obligations. If project delays occur, for instance, property owners could source the added costs from the payment percentage that they had been withholding from their contractors.
In theory, retainage should incentivize both property owners and construction participants. In practice, however, lower-tier contractors usually end up “self-financing” their services. With the payment being withheld from them, they have to find ways to perform their work with limited finances on hand.
How retainage works
In general terms, a property owner keeps a percentage of the full contract amount by deducting the progress payments that they release to their contractors.
If, for example, a contract is worth $100,000 and is payable in 10 months, amounting to a $10,000 payment for each month. If the agreed-upon retainage amount is 10%, the paying party will release only $9,000 per month. The remaining $10,000 that will complete the full contract amount will only be released after the project has wrapped up in 10 months.
This is just a general example, as there are specific statutory rules that regulate the use of retainage in each state. The terms and conditions of the retainage may also depend on the agreement between the parties involved.
It is worth noting, however, that retainage is widely practiced in public construction. When working on government projects, you will likely have to deal with a portion of your complete payment being withheld by the government.
How do property owners, general contractors, and government entities benefit from retainage?
Construction projects can be very complicated and they do not always run as planned. There are certain scenarios in which paying parties have to be protected from being ripped off by other construction parties.
1. Contractor defaults from a job
There are many reasons why a contractor could default on an ongoing project, but once they do, property owners or government entities may no recourse in successfully completing the project without having to spend a lot of money.
If a contractor defaults on a project and owners have retainage, they can use the retained payment to have the project completed.
2. Contractor fails to pay subcontractors and lower-tier parties
Retainage can also be used by property owners to pay subcontractors, material suppliers, and other parties down the contracting chain in the event that the contractor fails to fulfill their obligations. This protects property owners from having to pay double: to the general contractor and to the sub-parties who most probably have valid lien claims.
3. Contractors, subcontractors, and suppliers move on to another job without finishing their ongoing project
Another unfortunate scenario in construction is when participants move on to another job without completing their current project. A contractor may also find better opportunities elsewhere and deliberately rush through their current job, sacrificing their work’s quality.
In cases like these, paying parties can greatly benefit from retainage. It allows them to penalize the contractor, subcontractor, or materialman and also have the project completed by using the retainage funds.
How does retainage affect contractors, subcontractors, and material suppliers?
Retainage has benefits for property owners, general contractors, and government entities, but it can also be prone to abuse, which greatly affects lower-tier parties, specifically subcontractors.
1. Subcontractors are forced to “self-finance” their work
Not all subcontractors can afford a cut on their paycheck, so a retainage only clogs up their cash flow. Subcontractors end up funding their own work by tapping different financing methods in order to keep a project going.
2. General contractors may charge their subcontractors and suppliers a higher percentage
General contractors are also subjected to retainage imposed on them by a property owner or a government client. Sometimes, however, they increase the retainage percentage that they take from their subcontractors’ paychecks.
This practice, unfortunately, adds burden to subcontractors and suppliers, especially those who work on a project for a limited period of time.
A subcontractor or a material supplier, for example, may be needed only for the first few months of a project. The general contractor, on the other hand, has to stay until the project is complete and will therefore hold on to the retainage amount until they get their own full payment at the end of the project.
3. General contractors may choose to let the project remain unfinished
Sometimes, a general contractor may end up deliberately not completing a project, only because they do not have the money to pay back the retainage that they kept from their suppliers and subcontractors.
Cash flow mismanagement is a huge issue among construction businesses. When a general contractor keeps a project unfinished, their subcontractors and suppliers end up getting ripped off of the retainage amount.
Arguments against retainage
Although designed to protect all parties involved, construction retainage has also raised eyebrows. Here are some of the reasons behind this.
1. Retainage can be prone to abuse.
As mentioned above, there are instances when retainage fails to adhere to its purpose of ensuring that contractors deliver quality work on a project. Sometimes retainage causes contractors and subcontractors to clog their cash flow and only property owners end up benefitting from the retained funds.
2. Retainage puts smaller and lower-tier contractors at a greater financial risk.
Retainage limits the cash flow of any construction business, but not all companies can afford to deal with a dent in their finances. While retainage works under a noble principle, it can possibly cripple smaller businesses that do not have the means to deal with abusive owners or general contractors.
3. Retainage masks poor project and financial management.
When property owners or general contractors mismanage their funds, they end up losing the money that they retained from their subcontractors and material suppliers. Retainage is therefore sometimes used to get “free” money from lower-tier parties, instead of it actually being kept in the safe until the final day of the project.