As a retirement saving option, the National Pension System (NPS) is a well-known investment vehicle. Much of the attention (and rightly so) centres around the tier-1 option, with relatively less interest generated relating to the tier-2 choice.

Given that tier-2 is an additional option given to investors so that they have some flexibility in withdrawals. It is a voluntary saving option, unlike the tier-1 funds which are retirement vehicles with rules on contributions, taxes and withdrawals.

Specifically, tier-2 funds also offer the same options as equities, corporate bonds and government securities as tier-1 schemes. You can make contributions to tier-2 schemes at any time and also withdraw amounts without any restrictions. Of course, you are allowed to open a tier-2 account only if you have an active tier 1 NPS account.

However, the one key difference is that tier-2 schemes do not enjoy any tax benefits.

Like tier-1 funds, many tier-2 funds have been around since 2009. And the fund management charges remain very low – 0.09 per cent for the first ₹10,000 crore assets under management (AUM). Some fund houses charge even lower rates. Even if other transaction, maintenance and service charges are taken into consideration, the expenses are much lower than any other market-linked investment.

As we did with the tier-1 schemes that had a track record of 10-plus years in our bl.portfolio edition dated July 13, 2024, Choosing the Best Tier 1 National Pension System Fund, we review tier-2 funds’ performance here. Specifically, we assess the performance of tier-2 NPS schemes over September 2014 to September 2024.

We also present the return scenario when equity, corporate debt and government debt are mixed in a hybrid set-up. We have ignored scheme A (alternative asset funds), as it is yet to pick up significantly and assets managed are still quite insignificant.

Read on to take an informed call about how you can use tier-2 funds suitably despite it not having any tax benefits.

We assume that ₹1 lakh is invested on the 15^th of every September for the past 10 years. Then, using the net asset value (NAV) data and units accumulated over the years in the case of equity, corporate debt and g-sec schemes of various pension fund houses, we calculate the XIRR (extended internal rate of return) percentage for the 10-year period.

This is similar to calculating XIRR for an annual systematic investment in mutual funds.

The same exercise is done with the benchmarks. For equity funds, we have taken the Nifty 50 TRI as the benchmark.

In the case of corporate debt and g-sec schemes, data on specific indices are not easily accessible. Therefore, we decided to choose from among the top 5-star-rated mutual funds from bl. portfolio’s Star Track MF Ratings in the case of corporate debt. ICICI Prudential Corporate Bond Fund was taken for comparing the performance of corporate debt schemes.

In the case of g-secs, SBI Magnum Constant Maturity was taken as a benchmark, as it had a healthy track record in excess of 10 years, though there is no rating for the fund. Only six pension fund houses have a performance record of more than 10 years with tier-2 schemes. Schemes of SBI, UTI, LIC, ICICI Prudential, HDFC and Kotak have been taken for analysis.

Across categories, the analysis of scheme performances reveals that all fund houses have done better than benchmarks and delivered well. Their XIRR was higher than those of the benchmarks we used.

In the case of equity funds (E), the six funds have delivered XIRR in the range of 15.36-16.58 per cent over the 10-year period. HDFC pension Fund topped the charts with 16.58 per cent returns, followed by ICICI Prudential at 16.57 per cent. LIC recorded the lowest return, but was still reasonable at 15.36 per cent. The Nifty 50 TRI’s returns on an XIRR basis over these 10 years stood at 14.45 per cent. Thus, all the equity schemes of all six fund houses beat the benchmark convincingly.

The small difference in returns still turn out to be large sums when taken over the long term. For example, the ₹10 lakh invested over 10 years in HDFC’s equity scheme gave over ₹25.61 lakh, while LIC’s fund was worth a little over ₹23.86 lakh, nearly ₹1.75 lakh less than the former!

With respect to corporate debt schemes, again, all the six schemes outperformed the benchmark ICICI Prudential Corporate Bond Fund’s 10-year XIRR of 7.53 per cent. HDFC once again topped the chart with 8.11 per cent, followed by LIC at 8.07 per cent. Kotak’s scheme was relatively lukewarm, at 7.69 per cent, but still outperformed our benchmark. The difference in the value of the fund after 10 years between the best and worst performer was a relatively low ₹37,099.

With respect to g-sec schemes, LIC came on top with 8.94 per cent returns, followed by SBI at 8.36 per cent and HDFC at 8.35 per cent. UTI’s fund was at the bottom of the pack, though returns were still reasonable at 8.18 per cent returns. All schemes outperformed the SBI Magnum Constant Maturity Fund’s 10-year XIRR of 8.03 per cent.

The difference in the fund value of the best and worst performer was a relatively large sum of ₹70,185.

To get a clear picture on which fund to choose based on different asset-class performances, we assumed ₹1 lakh would be split across the three categories. So, 50 per cent investment would be in equities (E), 25 per cent in corporate debt (C) and 25 per cent allocation to government securities (G) over the same 10-year period.

A 50:50 equity-debt hybrid fund structure is what we envisaged as a generic hybrid fund like case. Some investors may have a different allocation pattern. Based on this allocation pattern, HDFC came across as the best pension fund house with an XIRR of 12.92 per cent, closely followed by ICICI Prudential at 12.88 per cent.

For perspective, a benchmark with 50 per cent Nifty, 25 per cent ICICI Prudential Corporate bond Fund and 25 per cent SBI Constant Maturity Fund would have delivered an XIRR of 11.44 per cent over the September 2014-24 period. HDFC and ICICI Prudential pension fund houses can be considered by investors if they intend to invest across all three classes.

But here is an important point. The NPS tier-2 funds enjoy no taxation benefits – whether in the form of deductions at the time of contribution or at the time of withdrawal.

All gains made in NPS tier-2 funds are added to your income and taxed at the applicable slab rate, irrespective of the proportion of equity and debt in your investment mix. Does it mean that these funds need to be shunned? Not necessarily.

The scheme choices C and G can be used for fixed-income allocation in your portfolio similar to debt mutual funds, especially as expense ratios are lower than the latter and returns comparably good or even better in some cases. Those wanting debt exposure alone via their NPS tier-2 funds can consider LIC and HDFC.