By Andrew R. Bodner
What Is Retainage Good For?
-Retainage may be a dirty word to some contractors, but it can work for contractors, if they know what to do. Retainage
Substitution work can provide appreciation and cash flow that may help contractors lower their bid for a contract or increase the
return on otherwise dormant dollars.
Retainage Substitution can work effectively for contractors. When facilitated properly, it may proved a wonderful means of
appreciation and cash flow to help lower their bid for a contract, or to increase the return on otherwise dormant dollars. Most
contractors agree the number of bidders on public contracts has increased dramatically. As competition increases, profits generally
decrease. Contractors submit a bid based on their estimate of the cost to complete a job with a reasonable profit. Contractors
cannot, however, factor in weather or other unexpected profit-diminishing events. This has led many contractors to seek Chapter 11
bankruptcy protection and subsequently exit the business.
Let us examine for a moment why contractors are in this current state of affairs. It starts at the top. Because of its budget
woes, the federal government avails less money to the states. The states in turn, looking to cut their own budgets, must restrict
construction improvements to its aging infrastructure system. Stated simply, fewer contracts are available for contractors to bid;
consequently, contractors must reduce customary profit margins. Indeed, the 1990s had been a rough decade for contractors.
With this in mind, contractors constantly seek methods to increase cash flow. For more than twenty-five years, public
agencies have been withholding Retainage money from contractors’ monthly estimates. This money is withheld not because of a
conflict, but because of the state’s written statues. Generally, the statues are written as follows: any contractor working in the
public sector shall have a percentage of each estimate withheld and placed in a non-interest bearing account. The money is held as
collateral should the contractor fail to complete the job. When all work is completed to the engineer’s satisfaction, the Retainage is
returned to the contractor, although sometimes years later.
Contractors earn nothing on those retained dollars; in fact, it appears that several agencies actually invest the funds for
their own benefit. Retainage is quite a dirty word to contractors. Both the principals and the chief financial officers do not like it;
their accounts certainly do not like it either, yet Retainage still exists nonetheless. Almost all contractors have Retainage withheld
from their monthly estimates. The amounts range from as low as two percent to as high as ten percent. If a contractor has a
twenty million dollar job spanning two years, he may be billing one million dollar per month. If the agency is withholding five
percent of this estimate, he or she is losing the use of $50,000 each month.
AN ALTERNATIVE
Many contractors are unaware that there is an alternative to permitting an agency to earn interest on their money. In many
states, in the public sector, the contractor may substitute approved securities for the cash Retainage. With this practice, a
contractor essentially collateralizes the Retainage with securities (generally treasury bonds or municipal bonds issued in that state or
municipality). The agency will subsequently release the Retainage dollars to the contractor. It is important for the contractor's
representative to discuss this procedure when in a pre-bid conference if a particular state does not provide for this procedure in its
statutes.
Usually a contractor will contact a "Retainage Specialist" at Double Diamond Investment Group, LLC (“DDIG”) to manage
this procedure. DDIG may initiate contact with a bank that will act as a custodian. DDIG must purchase a sufficient quantity of
marketable securities whose liquidation value is at least equivalent to the amount of cash Retainage to be substituted. After the
contractor pays for the purchase, DDIG will deliver the securities to the bank. The bank will then notify the agency that it is securely
storing the securities. The agency then releases the cash to the contractor. This process could take as little one day or as long as two
months, depending on the particular agency. In this way the contractor has in effect substituted securities in lieu of the cash
Retainage for a particular contract and turned dormant dollars into an income-generating investment. A contractor might consider
using these dollars to lower a bid that he or she would otherwise submit at a higher level allowing that individual to bid more
aggressively.
Flow Chart to Investment Advisor from Brokerage Firm
How It Works
4) Retainage Dollars
Released
Fidelity Investments 2) BONDS
3) Notice of Receipt
BANK
(Custody Acct.)
1) Contractor sends cash
RETAINAGE SUBSTITUTION PROCEDURE
There are several reasons why contractors would use the services of a "Retainage specialist" as opposed to initiating the
procedure themselves, including time, money, research and experience. When a contractor is awarded a job, he or she needs to
understand the particulars of a Retainage substitution. For example, in one instance the contractor may have as much time as he or
she needs to facilitate a particular substitution and in another situation, have just ten days to respond to the agency. In a third
situation, he or she may be able to substitute securities just once, regardless of the size of the contractor the time it will take to
complete the transaction in other jobs he may substitute as often as he or she chooses. In yet another situation, generally applying
to local work vs. state agency work, the contractor might spend several hours speaking to the municipality to explain what he or she
wants to do and how the law allows him to do so. Since the municipality will most likely be unfamiliar with this procedure and is
naturally leery of it, it may be several months until every financial person in the town and its law department has reviewed it and
voted on it. In these situations, and they are frequent, it is imperative to work with an experienced advisor that can get this
procedure approved expediently. This "specialist" will therefore save the contractor a tremendous amount of time and money.
A contractor earns substantial dollars through Retainage substitution. Here is a specific example: Assuming a four percent
rate for short-term municipal bonds, a $10 million dollar contract with a five percent Retainage factor and a two-year length may
earn $30,000 tax free. Now multiply this by three or five jobs of this size and this becomes a substantial means of augmenting cash
flow.
NOT FOR ALL
Contractors often question whether they are large enough to use the Retainage substitution. Unfortunately, this process is
not for everyone. It is restricted to prime contractors in the public sector. Although the private owner may allow a substitution, that
individual is not governed by public law and may therefore reject a contractor's request to substitute securities for the cash
Retainage.
The law pertains there are currently thirty one states that allow a prime contractor to substitute securities for the cash
Retainage. Contractors and advisors alike should persistently contact states and their legislature to provide for this practice. We
worked directly with the state of Florida to change their law. Georgia is also discussing updating its laws. If the remaining laws are
to be changed, contractors must contact their local affiliations (i.e.: The Association of General Contractors) to let them know this
should be an area of focus when dealing with that particular state's congress. Since Retainage substitution involves investing in
municipal bonds of the state in which the contractor is working, new markets are created for the bonds. States view this favorably as
it may allow them to issue bonds at a lower rate.
factors:
What size job is applicable to substitute? This question is often asked, yet cannot be answered without determining several
1.
2.
3.
4.
The
The
The
The
size of the contract;
length of the contract;
Retainage factor; and
custodial fees.
With these four factors considered, the contractor and Retainage advisor would consider the costs involved to the
contractor, which vary greatly from agency to agency and state to state. Generally, the contractor bears the cost of the annual
escrow account fee from a bank's trust department.
The bank may also charge the contractor for each transaction (i.e.: receiving or delivering a security). These are the two
primary fees, but a particular agency may charge additional fees. If an agency does not require the securities to be held in a bank
escrow account, they may instead be held at the brokerage house. Most brokerage firms carry insurance to protect the client's
assets. With these factors considered, contractors can determine which jobs may be applicable by examining the potential cash flow
to be earned minus the costs that would reduce this figure. If the cash flow is substantially greater than the costs, the contract
Retainage could become a cash cow.
If a contractor decides to participate in a substitution, he or she should expect securities to be purchased and delivered to a
bank that will notify the agency that it is holding the bonds. Once this procedure is established, the bank will send monthly
statements to the contractor and the agency advising them of what is held in the account and of its value.
At all times the bonds in the account must be greater than or equal to the value of the cash Retainage released. Since bond
prices can fluctuate before maturity, the portfolio value may decrease and be less than the minimum market value required by the
agency. In that event, the contractor must deposit cash or additional securities to the account to cover the shortfall. Consequently,
we advise contractors to follow a more prudent method for investing these dollars. Conversely, in periods of lower interest rates, the
portfolio would appreciate in value. Certain agencies will take this into account when facilitating the next substitution. A contractor
may, however, wish to maximize the cash flow by depositing long-term bonds into the escrow account. However, when the job is
completed, a contractor may want his or her investment completed and the Retainage exchanged to cash.
If long-term bonds are purchased, and interest rates have risen, a contractor may find the value of the bonds has substantially
decreased, requiring the deposit of additional securities or cash. In addition, if a contract ends and a contractor is holding long-term
bonds, he or she may be forced to sell the securities to pay a material supplier or subcontractor, which could result in a capital loss.
To eliminate this "extension" risk, a contractor could invest in bonds at a discounted dollar price and with a maturity coinciding with
the completion date of the contract. In this manner, there is a little chance that a contractor would be forced to deposit additional
money to the escrow account. Further, it significantly increases the chance of a profit if bonds are held or sold prior to maturity.
Retainage substitution seeks to provide additional income, not maximum income. Most or all of the profit is in the
Retainage, hence, a contractor should not want to risk the principal.
All "Retainage Specialists" have their own methods, but an advisor must provide a full paper trail for the contractor. The
contractor should receive written confirmation of the most recent investment made. In addition, each time an investment is bought
or sold; a new portfolio ledger should be generated and sent to the client including a full description of the bonds, where the bonds
are located, what job the bonds are pledged to, and the cost basis and purchase date, among other things. This ledger sheet gives
the contractor a quick overview of what is in the portfolio as well as what bonds are substituted for which job. In addition, the
brokerage firm should supply a cash flow summary to the contractor if money is borrowed for the purchase of securities, including a
description of the bonds, the cost of the bonds, purchase date, when bonds were sent to the bank's trust department (if applicable)
and when the agency released the cash Retainage to the brokerage firm. This form will tally interest for the loan of the investment.
A contractor may have the option of investing in either treasury securities or municipal bonds of a particular state (although this
investment election varies state to state). Maturities range from one day to thirty years and anywhere in between. Since bonds
fluctuate with interest rates (short-term bonds fluctuating much less in price than longer term bonds), choosing the right investment
for a particular need is vital. An experienced advisor should be able to help a contractor determine what investment is right for that
contract and contractor.
Another Option
For a contractor who works exclusively or extensively in a particular state, another concept may apply. Instead of investing
in bonds with a two year maturity for a two-year job, the contractor might invest in bonds with longer term maturities. When the
contract is complete and bonds are released, he or she would not sell the securities, but could instead transfer the bonds to a new
job. In this scenario, not only does the contractor receive the benefit of the interest income, he or she also obtains the use of the
Retainage money since the Retainage specialist will deliver fully paid for securities to the new job.
In addition, this method allows a contractor to earn a better return by extending the maturity and also saves the cost of
purchasing new bonds. Also, bonding companies look favorably on Retainage investing as the contractor is structuring a portfolio of
hard assets, with an emphasis on capital appreciation.
Ultimately, the contractor should look to develop a portfolio of securities that may be transferred from job to job, and will
make Retainage more palatable as he or she enjoys cash flow from Retainage dollars. With this achieved the word Retainage may
no longer be viewed as a dirty word.
Andrew Bodner is a Certified Financial Planner, Owner and
President of Double Diamond Investment Group, LLC. Mr.
Bodner, age 44, began his professional career in
1987, specializing in municipal bonds at a regional bond firm
This article was first published in Journal of Construction Accounting & Taxation, Winter 1997