The reasoning behind contract retention is simple; money motivates. The purpose of retention — also known as retainage — is to incentivize contractors to complete a job according to the contract terms by withholding a portion of their payment until all agreed-upon project milestones have been met. It’s like a risk management strategy to ensure job completion.
The practice started in the mid-1800s in the U.K., and has continued in the U.S. for more than 100 years as a way to guarantee certain outcomes, including:
- As extra insurance for owners that the job will be done.
- As a way to guarantee work will pass quality control requirements, not only meeting workmanship standards, but that the materials aren’t inferior to what the owner expected.
- As a form of protection for owners against work that isn’t completed to their project requirements.
But contract retention serves more than just project owners’ needs. Contractors are often a part of negotiating the retention plan in the early stages of the contract to ensure realistic expectations for the project, set up payment terms and protect their own profit margins.
Two levels of retention are often in play on a project:
- Owners build a retention clause into the construction contract that withholds a certain percentage of the monies owed to the contractor until the job is completed and verified free of flaws. So, if the contractor doesn’t complete the project or correct any mistakes, they forfeit the retention money.
- Likewise, contractors often have a retention policy with their own subcontractors and suppliers to guarantee that the work — which the contractor is ultimately responsible for — is accomplished according to spec.
This practice is unique to the industry and is so ingrained in construction culture that it’s regulated in the U.S. by the federal government as well as in each of the 50 states for public works projects. And in all states except New Mexico, private or commercial project contracts are also allowed to include retention clauses.
The typical range for contract retention for a contractor can vary by state and is largely determined by the owner and contractor per project. It hovers between 5-10% and can skew slightly higher for subcontractors. Federal and state projects typically have a lower rate than for private projects. As a percentage, it may not sound like much at first. Afterall, the contractor is still getting 90-95% of their fee. But translate that percentage into hard dollars and it takes on a different outcome. It can amount to a substantial chunk of money, even more so when it’s for a sizable project like a hospital, commercial building or power plant. And it is likely the contractor will be using much of that retained portion to pay for subcontractor wages and other project-related expenses, making timely remittance all the more impactful.
As far as private projects go, there are legal limits to how much retention a project owner can withhold, for how long and how it’s paid out. But again, they are state-specific and don’t have the kind of protections in place like government projects do. However, states may impose interest penalties if an owner misuses the retention money.
While the benefits may make sense from a risk management perspective, the practice has some inherent challenges, such as:
- Effectively tracking who is subject to retention, how much and when to pay them can be difficult to manage. This is because sifting through and accurately calculating the dozens or even hundreds of retention-contingent invoices on a regular basis can be a rather lengthy process when done by hand or computer spreadsheet, as is often the case in construction, and especially so for larger projects.
- It can take months for contractors to receive retention pay. For their subcontractors, it could be much longer than that if their portion of the project is finished before the contractor’s is. The reason being that many contracts stipulate that retention won’t be paid until the entire project is done, which includes the quality assurance/defect liability phase to check for any flaws in the work.
- Withholding pay from contractors can create a cash flow problem for tight-margin projects, especially if the margin is less than the retention percentage. This may affect their ability to pay subcontractors while also footing the bill for equipment and materials necessary for the job. A contractor’s reputation may suffer if they’re unable to pay subcontractors due to the retention money being withheld.
Thankfully, today’s best construction management software can help all parties proactively manage contract variables in a more timely, efficient manner — from workflows to contract financial integrations to project life cycle transparency — helping to ensure all of your projects meet their contract conditions successfully with the least amount of frustration or inaccuracy.
Solutions like InEight Contract help you better meet your contractual obligations without missing any critical milestones that could impact contract retention payments. You get visibility into your project progress, so you can manage all aspects of your contract development, track payment obligations and manage subcontractor workflows. We’re happy to walk you through a demo of how it can help you.
