Retention Bonds

Retention bonds are a financial instrument used in construction projects to replace traditional cash retention practices. They ensure that contractors fulfill their post-completion obligations, while allowing clients to release withheld funds.

A retention bond is a surety bond that guarantees a contractor completes the work and addresses any defects during the warranty or defects liability period.

In traditional construction contracts, clients often withhold a percentage of the contractor’s payment, typically 5–10%, until the project is fully completed and all post-completion obligations are met. This practice is called retention or retainage. While retention ensures contractors are incentivized to finish the project properly, it can create significant cash loss for contractors, tying up funds that could otherwise be used for materials, labor, or other project costs.

A retention bond replaces this cash retention practice. Instead of withholding funds, the client receives a surety-backed bond that guarantees any incomplete work or defects will be remedied. Contractors benefit by receiving full payment upfront, improving liquidity and reducing the risk of cash flow shortages. Meanwhile, the project owner or client maintains financial protection, knowing the surety will cover costs if obligations are not met.

Purpose:

• Protect clients and project owners from financial risk
• Ensure contractors meet post-completion obligations
• Improve cash flow for contractors by allowing full upfront payment

A retention bond guarantees that a contractor will complete the work and address any defects during the warranty or defects liability period. It involves three main parties:

• The principal – the contractor responsible for completing the project and fixing any post-completion issues.
• The obligee – the project owner or client requiring assurance that the work will be completed and any defects remedied.
• The surety – the bonding company that issues and backs the bond.
   

The process begins with the contractor paying a premium and submitting project details, including plans, budgets, and financial information. The surety evaluates the contractor’s experience, financial stability, and project risk before issuing the bond.

If defects arise or work remains incomplete during the retention period, the obligee can file a claim on the bond. Any funds advanced by the surety must typically be reimbursed by the contractor under a general indemnity agreement. Premiums are calculated as a percentage of the contract value based on project scope and risk.

Retention bonds protect project owners while allowing contractors to receive full payment upfront and ensuring post-completion obligations are met.

The cost of a retention bond is typically calculated as a percentage of the total contract value, reflecting the project’s size, scope, and financial risk. Premiums usually range from 1% to 3% for contractors with strong financial profiles.

Key factors that influence the cost include:

• Contract value: Larger projects with higher contract amounts require higher bond coverage, increasing the premium.
• Project complexity and risk: Projects with multiple trades, tight schedules, or technically challenging work can raise the surety’s risk assessment and slightly increase costs.
• Credit and financial strength: Contractors with strong credit and proven financial stability are viewed as lower risk and generally qualify for more favorable rates.
• Experience and claims history: Contractors with a history of completing projects without defects or claims typically pay lower premiums.
• Surety company: Premiums vary based on the surety’s assessment of risk and appetite. Working with reputable sureties ensures reliable coverage and competitive pricing.
   

For example, a $1,000,000 project backed by a contractor with excellent credit might have a retention bond premium between $10,000 and $30,000 annually, depending on project complexity and risk factors.

While retention bonds focus on post-completion obligations and retained funds, other bonds serve different purposes:

• Performance Bonds: Guarantee that specific contractual work is completed according to standards, usually during the project.
• Payment Bonds: Ensure subcontractors and suppliers are paid.
• Completion Bonds: Guarantee the overall project is finished on time and within budget.
   

Retention bonds are typically used alongside performance bonds, especially when clients want to release retainage while still maintaining protection.

When a contractor fails to remedy defects, complete work during the warranty or defects liability period, or otherwise defaults, the project owner can file a claim on the retention bond. 

1. Notify the Contractor
   Provide the contractor a reasonable opportunity to correct deficiencies or complete the work. Document all communications to support your claim.
    
2. Gather Documentation
   Collect contracts, project plans, inspection reports, photos of defective or incomplete work, and any correspondence or invoices demonstrating unmet obligations.
    
3. Identify the Surety
   Review the bond to determine which surety issued it and follow their specific procedures for submitting a claim.
    
4. Submit a Written Claim
   Prepare a detailed claim describing the defects or incomplete work, including estimated costs for remediation, and attach all supporting documentation.
    
5. Cooperate with the Surety
   The surety will investigate the claim, which may include site inspections or discussions with the contractor. Respond promptly to any requests to avoid delays.
    
6. Resolution
   If the claim is approved, the surety may pay for another contractor to fix the issues, require the original contractor to complete the work, or reimburse the project owner for costs incurred.
    
7. If the Claim Is Denied
   If the surety denies the claim, legal advice may be necessary to enforce rights under the bond agreement.

Can a retention bond be transferred if the project changes ownership?

Generally, no. If the project ownership or contractor changes, a new retention bond or surety approval is usually required to maintain coverage.

Do retention bonds cover all types of defects?

Retention bonds cover defects or incomplete work specified in the contract and warranty period. Cosmetic or unrelated issues may not be covered.

How long does a retention bond remain in effect?

Retention bonds remain active for the duration of the defects liability or warranty period, typically until the contractor’s post-completion obligations are fulfilled.

Can a retention bond be canceled before the defects liability period ends?

Cancellation is possible but usually requires the surety’s approval and agreement from the project owner. Any risk to project protection must be mitigated before cancellation.

Is a retention bond mandatory?

Retention bonds are not generally required by law but are often requested by project owners, clients, or lenders who want to release retainage while protecting themselves financially.

Does a retention bond guarantee quality of work?

No. A retention bond guarantees that post-completion obligations, such as correcting defects, are financially backed. Quality standards are enforced through contracts and inspections.

Can one retention bond cover multiple projects?

Typically, retention bonds are project-specific. Blanket coverage for multiple projects is possible but requires approval from the surety and may involve additional underwriting.

What happens if a claim is made and funds are paid by the surety?

The contractor (principal) is obligated to reimburse the surety for any payments made under the bond, as agreed in the General Indemnity Agreement (GIA).