Imagine you only pay 90% of the price of a shirt, wear it a few times, and then pay the balance after you decide that you like it. Now, imagine that same clothing retailer telling the supplier that it will get its last 10% only after you are satisfied and pay the last 10%.
This scenario is laughable – it is simply not how business is done. Yet, in the construction industry, this payment arrangement is the norm.
Known as retainage, this concept provides the owner or upstream party the right to hold back money earned until a later time, when it is disbursed under specified conditions.
This concept dates back at least to the 1840s, when the construction of a national railroad system in England was plagued by a high rate of contractor defaults. The railroads started holding 20% of the contract amount to cover extra costs. The idea quickly spread to the U.S., where it has been a fixture in construction for more than 175 years.1
This practice is not without regulation, and states limit how much can be held back and for how long. Depending on the state, retainage may be restricted to 5% or 10% of the total project value and may be released at different times, ranging from substantial completion to when the work is accepted. Retainage rates may also be adjusted or modified based on the owner’s level of confidence in the contractor’s work.
How Does Retainage Work?
Construction generally requires significant time and money. However, most contractors cannot wait until after the work is complete to be paid.
So, contractors are generally paid incrementally throughout the project as work is successfully accomplished. This provides contractors with better cash flow. But by making such payments, owners risk not having enough money to complete the project. For an owner, retainage offers a type of insurance.
Retainage also incentivizes contractors to complete their own work: Knowing that money they have already earned is waiting unpaid, contractors are more likely to finish small items themselves. Retainage has become a mechanism to balance the contractor’s need for advance payments with the owner’s interest to ensure final completion.
However, retainage often has the unfortunate effect of turning contractors and subcontractors into project financiers. In practice, the owner’s agreement with the GC will provide for a set amount (e.g., 10%) to be held until the project achieves substantial or final completion.