Every contractor knows that, at least in most cases, they won’t be paid the full amount that they’re owed until after a project is completed. That’s because of a principle known as “retainage.”
Retainage is commonly used in the construction industry, and it’s meant to incentivize contractors to do quality work while also protecting the interests of project owners and subcontractors.
What is retainage in construction? Here’s a detailed breakdown of retainage and how it works.
The Basics of Retainage in Construction Contracts
Retainage is the practice of holding back a percentage of the price of a construction project until the work has been completed and signed off on.
This serves as a powerful incentive for contractors to ensure that work is correct and complete. It also gives the project owner leverage if they find issues with the work. Generally, the specific amount of retainage is detailed in the contract, but many states and cities have laws regulating (or even requiring) retainage.
Construction contracts typically specify where retainage money must be kept until the completion of the project. It’s often held in an escrow account or trust fund.
How Retainage Is Calculated and Withheld
In most cases, contractors are paid at regular intervals over the course of a project to ensure that they have adequate cash flow. The agreed-upon retainage amount is usually subtracted from each periodic payment and placed in a separate account.
Imagine that a construction company is working on a large project. The payment schedule outlined in the contract specifies that the project owner must make 10 payments of $30,000 each. It also specifies a 10% rate of retainage.
This means that out of every $30,000 payment, $3,000 is held back, and the owner pays the contractor $27,000. By the end of the project, there will be $30,000 in retainage.
That amount may be released to the contractor once the project has officially been completed or after a set period of time has passed after completion, depending on the contract and state laws.
Where Did the Concept of Retainage Come From?
Retainage has been around much longer than many people realize. It started with the “Railway Mania” of the 1840s in the United Kingdom of Great Britain and Ireland. During this period, investors poured vast sums of money into the railroad industry, leading to a proliferation of new rail companies and a spike in demand for railroad infrastructure.
The demand was so great that established railroad contractors couldn’t keep up. That meant many of the people tasked with building the new railroads didn’t have the experience to do so properly.
In an effort to cut back on the subpar (and sometimes dangerous) craftsmanship they were seeing, railroad companies began holding back a portion of what they owed until the conclusion of the project. They only released the money after verifying that the work had been completed correctly.
During this time, rates of retainage could be very high. Some railroad companies withheld as much as 20%.
How Retainage Benefits Different Parties
Understandably, some contractors view retainage as unfair. However, while the practice may not always be ideal, it does offer benefits for many of the parties involved in a given construction project.
Project Owners
Without retainage, there’s a chance that a contractor might abandon a project after the last progress billing payment. They may choose not to address any remaining issues with the project, leaving the project owner to find (and pay for) someone else to finish it.
Retainage incentivizes contractors to deliver high-quality work and to do so efficiently. And if the contractor defaults despite the retainage, the project owner may use the withheld money to pay someone else to complete it.
Contractors
Many contractors consider retainage a disadvantage, but if they work with subcontractors, this setup can often be beneficial. When the contract between the primary contractor and the project owner includes retainage, contractors typically use the same percentage of retainage with their subcontractors.
As such, contractors have leverage of their own. Their subcontractors know that if they fail to complete their work or don’t do it adequately, they may not be paid all that they’re owed.
Subcontractors
If a contractor defaults on a project, the project owner isn’t the only one being left in a lurch. In many cases, they also fail to pay subcontractors properly. When this happens, subcontractors can usually recover the rest of their payment from the retainage held by the project owner.
Lenders and Insurers
Many people don’t realize that retainage impacts banks, other lenders, and insurance companies. When a particular construction contract includes retainage, it assures lenders and insurers that the job will be done correctly. As a result, these companies face less risk.
Who Sets the Amount of Retainage? Understanding Retainage Laws
Contractors and project owners must agree on the terms of retainage outlined in their contract. However, most states and many municipalities have laws regulating retainage.
For example, Texas Property Code §53.101 requires construction owners to hold back 10% of the contract price (or 10% of the value of the completed work). They must hold these funds for 30 days after the project is completed or abandoned.
This retainage law creates a kind of safety net for subcontractors and others who may be impacted if the primary contractor defaults. The 30-day hold period exists to allow subcontractors and building suppliers to claim the funds if the primary contractor fails to pay them.
Not all states require retainage, however. In some states, the contractor and project owner may negotiate a retainage rate, or they may elect not to have any retainage at all.
Advantages of a Retainage Clause
What is retainage in construction designed to accomplish, exactly? Retainage is widespread in the construction industry for good reason. The following are some of its key advantages.
It Incentivizes Efficient, Quality Work
Contractors know that in order to receive retainage, they must make sure their work is in line with client expectations. And because retainage includes funds withheld since the beginning of the project, contractors have an incentive to finish sooner rather than later.
It’s Effectively a Built-In Legal Remedy
If a contractor defaults on a project without retainage, the project owner would need to file a lawsuit or find another source of funding to finance the remainder of the project. Retainage gives them a way to pay for the work to continue if the contractor abandons it.
It Protects the Financial Interests of Subcontractors and Suppliers
When a contractor defaults, their suppliers and subcontractors may go unpaid. But if the project has retainage attached, these parties can recover what they’ve earned from the retainage the project owner sets aside.
Disadvantages of Retainage
Retainage has existed (and largely worked) for hundreds of years, but it’s not a perfect system. Here are some of its main disadvantages.
It Can Cause Financial Issues
For most contractors, financial constraints are the primary disadvantage of retainage. Many operate on tight profit margins, and, in many cases, most of their profit is tied up in retainage. Sometimes, the retainage amount is even greater than the profit they expect to earn.
Despite that fact, contractors have to keep paying their employees, cover insurance premiums, and pay for other expenses in full. It’s not unusual for retainage to lead to cash flow issues.
It May Disadvantage Subcontractors
In some instances, a particular subcontractor may only be involved with a project for a short time. However, funds in retainage are held until the entire project has concluded. This may mean that subcontractors have to wait many months (and possibly longer) to receive full payment.
It Can Lead to Abuse
Once a contractor completes a project to the project owner’s satisfaction, they expect to receive retainage promptly. However, some project owners deliberately delay the payout or exaggerate minor errors, essentially to force the contractor to work for free. Some may even refuse to release the funds unless the contractor agrees to a discounted payout.
It Complicates Recordkeeping
Retainage can add layers of complexity to a construction company’s accounting. Retained funds can’t just be lumped in with accounts receivable. Instead, they need to be tracked separately. Typically, payments from the project owner fall under accounts receivable, and retained funds are classified as retainage receivable.
For contractors who work with subcontractors, the waters can get even muddier. In addition to tracking their own retainage receivable, contractors must set aside and keep track of retainage payable, which is the retainage they’ll ultimately pay to subcontractors.
Simplify Retainage With Full-Service Accounting From Devine Consulting
Handling finances as a contractor is tough enough as it is. When you add retainage to the mix, it only compounds the challenges of accounting and bookkeeping.
Devine Consulting has been partnering with contractors, engineering and architecture firms, and construction companies since 2011. We offer personalized accounting, bookkeeping, and financial controller services. Our team can help you glean valuable financial insights to better understand what your business needs to grow.
We’re based in Texas, but we work with clients nationwide. To learn more about how we may be able to assist you, contact us to schedule a free consultation.