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 sums. 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.
The methodology
We assume that ₹1 lakh is invested on the 15th 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.
All tier-2 funds outperform
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.
Finally, 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.
Deciding the best
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. This has been clearly specified in the NPS Trust website itself.
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 all this mean that these funds need to be shunned? Not necessarily. Given that the expense ratio is very low and returns reasonably attractive, these schemes are still relevant.
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.
Where do schemes invest?
The investments across categories in these schemes are somewhat similar with key holdings largely differing only in weightages accorded to securities – equity or debt.
When the scheme E of fund houses is taken, investments are mostly in the top-100 market-cap stocks.
However, most of the tier-2 NPS funds restrict themselves to large-cap stocks from the Nifty 100 or largely to the Nifty 50 basket.
The likes of Reliance Industries, HDFC Bank, ICICI Bank, Infosys, TCS, L&T, HUL and Bharti Airtel figure in the portfolios of almost all the six fund houses. The top-five holdings account for 25-32 per cent of their portfolios.
Without getting into the frenzy of mid-cap stocks or taking undue risks, these funds have managed above-average returns over the long term.
In portion C, NPS funds are not allowed to take credit risk in their bond investments. So, most of these funds invest in debt securities that are rated AAA or AA for most part.
Bonds and non-convertible debentures of familiar public and private sector companies figure in their portfolios.
Debt securities of Bajaj Finance, Bajaj Housing Finance, NHPC, PFC, IOC, Reliance Industries, Shriram Finance, NaBFID, apart from SBI Infra bonds are commonly held by tier-2 funds.
The holdings are also diffused, with the top-five holdings in most of these funds less than 20 per cent of the portfolio.
The maturity profile is 4-15 years in most cases. Since investments are made to reputed corporate houses with ratings of AA or AA, the credit risk is low.
Schemes investing in scheme G, too, have a fair degree of overlap in terms of preferences for bonds.
NPS funds invest in government securities as well as State development loans (SDLs). A good part of the g-secs of the Central government bought are those maturing many decades from now. Some hold g-secs maturing in 2064. In general, most funds have securities maturing 15-25 years away.
The odd variation is funds investing in g-sec STRIPs maturing in 2029 or SDLs of Uttar Pradesh maturing in 2038.
Exposures to individual securities are a bit more concentrated with g-sec funds – the top five holdings account for 33-50 per cent of the portfolio.
When interest rates start to decline and bond inflows become heavy after India’s inclusion in global indices, yields may tend downwards on longer-tenor government securities. This may result in a upmove in bond prices, thus aiding fund NAVs. In fact, even without any rate cuts in India, bond yields have fallen significantly in the last six months to one year.
Across asset classes, NPS tier-2 remains a moderate risk investment.
The tier-2 may not enjoy any tax benefits. But you can consider using them for debt investments. You could also transfer proceeds from tier-2 schemes to the main tier-1 funds. You can switch the tier-2 to tier-1 online or approach the intermediary you employed to invest in the first place. Tier-2 corporate bond and g-sec funds are taxed like debt mutual fund schemes. The advantage you have is that there is no TDS deducted and taxes are payable only when gains are realised. You can consider allocating, say, 20 per cent of your debt portfolio to these funds. Of course, the day you close the tier-1 account, the tier-2 schemes would also be closed automatically.
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