NPS vs mutual funds: The ideal option for retirement?

Summary: NPS and mutual funds are now best viewed as complementary retirement tools: mutual funds should typically drive long‑term wealth creation, while NPS adds a low‑cost, tax‑efficient and rule‑based pension layer. The key is to understand how NPS actually works and then decide how much of your retirement plan it should occupy alongside mutual funds.

India still faces a retirement preparedness crisis, with most households relying on low‑return fixed deposits (FDs) and traditional term insurance plans that struggle to beat inflation.

This is where NPS (National Pension System) and mutual funds come in. These two investment avenues aim to solve two big problems – building a large enough corpus and then converting it into reliable income that lasts through a longer post‑retirement life.​​

Our story is designed to help investors decide whether NPS alone can serve as the core of their retirement plan or whether mutual funds should remain the mainstay. That decision framework rests on comparing costs, risk, flexibility and tax treatment of both options in the current environment.​​

NPS: Structure, lock‑in, annuity and where it invests

NPS is a government‑backed, defined‑contribution pension system designed to accumulate a corpus during working years and convert part of it into an annuity at retirement. Tier I is the primary retirement account with withdrawal restrictions, while Tier II is an optional open‑ended investment account without lock‑in.​​

Where NPS invests
Contributions are invested across four asset classes.

• Equity (E): Listed shares, predominantly large‑cap stocks, accessed through registered pension fund managers.
• Corporate bonds (C): High‑quality debentures and other corporate debt instruments.
• Government securities (G): Central and state government bonds, offering sovereign‑backed safety.
• Alternate assets (A): A small slice (capped at 5 per cent) in instruments such as REITs/InvITs.​

Under Active Choice, investors can allocate up to 75 per cent to equity (E) in Tier I, with the rest split across C, G and A within prescribed limits; in Tier II, equity allocation can go up to 100 per cent.​

Lock‑in and withdrawal rules (Tier I)

• The Tier I account is designed as a long‑term retirement vehicle and is effectively locked in until age 60, which is treated as the standard exit age.​​
• Partial withdrawals of up to 25 per cent of the subscriber’s own contributions are allowed after three years of account opening, for specified purposes such as children’s education, marriage, home purchase, certain critical illnesses and setting up a business; a maximum of three such withdrawals is generally permitted during the account’s lifetime.​
• Early exit before 60 is allowed after a minimum period (typically at least five years of contribution), but in such cases a larger portion of the corpus must usually be used to buy an annuity and only a limited amount can be taken as lump sum.​
• Recent changes allow the NPS account to be continued up to age 85, providing a longer investment window if the subscriber chooses not to exit at 60.​

Annuity and lump‑sum rules
At normal exit (around 60), NPS is structured as a combination of lump‑sum withdrawal and annuity purchase.

• For non‑government subscribers, new rules now allow up to 80 per cent of the corpus to be withdrawn as lumpsum in many cases, with only 20 per cent mandatory annuity, subject to thresholds.​
• If the accumulated pension wealth is Rs 8 lakh or less, 100 per cent can be taken as a lump sum; between Rs 8 lakh and Rs 12 lakh, up to Rs 6 lakh can be withdrawn immediately, with the balance used for annuity or structured withdrawal.​
• For larger corpuses and for government‑sector subscribers, the traditional 60:40 framework (up to 60 per cent lump sum, at least 40 per cent annuity) continues to apply.​ An annuity in this context is a product bought from a life insurer where you pay a lump sum and receive a fixed or variable income at regular intervals (monthly, quarterly, etc.) for life or a specified period, with the income fully taxable in your hands.​​
• In addition, the Systematic Unit Redemption (SUR) facility allows the non‑annuity portion of the corpus to be withdrawn in instalments over several years, letting the remaining NPS units stay invested while providing periodic cashflows.​

Costs and performance
Pension fund management charges under NPS remain extremely low, with caps around 0.09 per cent of AUM for fund management, plus small record‑keeping and PoP charges, making NPS structurally cheaper than actively managed mutual funds. 

In comparison, equity mutual funds (direct plans) typically charge total expense ratios ranging from about 0.5 to 2.5 per cent, and passive funds from roughly 0.03 to 1 per cent depending on category and size.​​

Value Research’s dedicated NPS performance section shows that equity‑oriented NPS schemes delivered strong calendar‑year 2023-25 returns in line with the broader equity rally, with several Tier II equity plans reporting one‑year returns in the high teens to high 20s as of late 2025. 

Over three‑ and five‑year periods ending December 2025, equity NPS options broadly track large‑cap and flexi‑cap mutual fund indices, but diversified mutual funds with meaningful mid‑ and small‑cap exposure often show higher long‑term category averages.​

Taken together, this means NPS provides disciplined, tax‑efficient, low‑cost accumulation with improving withdrawal flexibility, but still works best as one layer in a broader retirement portfolio rather than the only pillar.​​

Auto vs Active allocation within NPS

NPS offers two broad allocation modes: Auto Choice (lifecycle) and Active Choice (investor‑driven allocation across E, C and G plans).​​

Auto Choice (Lifecycle)

• Automatically adjusts equity exposure downwards as the investor ages.
• Well‑suited for beginners and mass‑affluent investors who lack the time or inclination to review and rebalance regularly.
• Reduces behavioural errors, which often hurt returns more than sub‑optimal allocation choices.​

Active Choice (Manual allocation)

• Allows investors to choose and periodically tweak the equity–debt mix within the prescribed caps.
• More suitable for experienced investors or HNIs who already manage sizable mutual‑fund portfolios and can coordinate NPS allocation with their broader asset mix.
• HNIs typically treat NPS as a small satellite (for example, 5-15 per cent of financial assets), using high‑equity Active Choice to complement a diversified, higher‑volatility mutual‑fund core.​

For most investors who are not professionally advised or highly engaged, Auto Choice remains the safer default; sophisticated investors can use Active Choice to fine‑tune NPS as one component of an overall asset‑allocation plan rather than a standalone portfolio. 

Watch this video Should one invest in National Pension System (NPS)? to get additional perspective on this choice.​​

Mutual funds: Flexibility, return potential and role in retirement

Mutual funds pool investor money and invest across equity, debt, hybrid and other strategies, with SEBI‑defined categories giving investors clarity on mandate and risk. 

For retirement, the practical building blocks are flexi‑cap or large‑cap biased equity funds for growth and high‑quality short‑duration or banking & PSU debt funds for stability and drawdown.​​

Return profile

• As of April 2024, 10‑year category averages were around 14.7 per cent for large‑cap funds, 21 per cent for mid‑cap and 23.1 per cent for small‑cap funds (direct plans). 
• Subsequent category data on Value Research through December 2025 show that while these precise numbers have moved with markets, the hierarchy remains intact: small‑cap and mid‑cap funds still show the highest long‑term category returns, followed by flexi‑cap and large‑cap funds. This is why diversified equity funds remain the workhorse for long‑term wealth creation despite higher volatility.​​

Liquidity and choice

• Except for ELSS (three‑year lock‑in), most open‑ended mutual funds allow redemption on any business day, subject to exit loads in some categories. 
• This liquidity, along with the breadth of categories, makes mutual funds better suited than NPS for both accumulation and a flexible post‑retirement drawdown plan.​​

2025–26: New NPS withdrawal flexibility and outlook

Recent regulatory changes have started to reshape NPS from a rigid ‘pension‑only’ vehicle towards a more flexible retirement platform, especially around exit age and how much can be taken as lump sum.​

• Higher exit age and longer investment window: PFRDA’s 2025 update allows NPS subscribers to remain invested up to age 85, up from the earlier upper limit of 75. This gives investors an additional 10 years of potential market participation and scope to stagger withdrawals in line with longevity and other income sources.​
• More generous lump‑sum withdrawal for smaller corpuses: For normal exits (post 60), if the total corpus is Rs 8 lakh or less, subscribers can now withdraw 100 per cent as a lump sum, up from the earlier Rs 5 lakh threshold. For corpuses between Rs 8 lakh and Rs 12 lakh, up to Rs 6 lakh can be withdrawn immediately, with the balance adjustable via staggered withdrawals (Systematic Unit Redemption) or annuity. Larger corpuses continue to be subject to a minimum annuitisation requirement, with government‑sector subscribers typically following a 60:40 lump‑sum‑to‑annuity split.​
• Systematic Unit Redemption (SUR): The newer SUR facility allows phased redemption of the non‑annuity portion over at least six years, effectively mimicking mutual‑fund‑style drawdown from within NPS while the remaining units stay invested. Combined with the higher exit age, this greatly improves NPS’s ability to support a more customised retirement income path rather than a one‑time switch into annuity.​

These changes weaken the perception that NPS is ‘quite rigid’ and ‘tough to withdraw’ before or after 60, because subscribers now have more options to stay invested, phase withdrawals and avoid locking too much into low‑yield annuities.​​

For a deeper dive into NPS structures and trade‑offs, see Mutual funds or NPS Tier‑2: Which is better?​

Tax treatment: NPS vs mutual funds

Tax rules remain one of NPS’s strongest edges, especially for investors still using the old regime, even as the policy thrust is clearly towards the new regime where most incentives are neutralised.​​

NPS tax benefits
Under the old regime, NPS offers:

• Up to Rs 1.5 lakh deduction under Section 80C (shared with other eligible investments) plus an additional Rs 50,000 deduction under Section 80CCD(1B), taking the total potential NPS‑linked reduction in taxable income to Rs 2 lakh.​​
• Employer contributions to NPS (up to prescribed limits) are also deductible under Section 80CCD(2), which is particularly valuable for salaried investors whose employers offer this facility.​
• On exit, up to 60 per cent of the corpus taken as lumpsum remains tax‑free (or higher lumpsum percentages where permitted under the new slabs), while the annuity income from the mandatory portion is taxed as per the investor’s slab in the year of receipt.​​

Mutual fund tax rules

• Equity‑oriented mutual funds (including most flexi‑cap and large‑cap funds) are taxed at an LTCG (long-term capital gains tax) of 12.5 per cent, while short-term capital gains (STCG) are taxed at 20 per cent. 
• ELSS funds provide Section 80C deduction of up to Rs 1.5 lakh under the old regime, but beyond that they have no special tax break versus other equity funds.​​
• Debt‑oriented funds are now taxed at slab rates on all gains, with indexation benefits largely removed for new investments, narrowing their tax edge over fixed deposits.​

New regime tilt
The simplified new tax regime significantly reduces the value of most deductions, including 80C and 80CCD(1B), making NPS’s incremental tax advantage less relevant for investors who opt for the new regime. This is a key reason why NPS is better viewed as a low‑cost, tax‑aware satellite to a mutual‑fund‑centric retirement plan.​

For more on tax‑efficient investing, Value Research’s webinar The right strategy to save taxes can be a useful supplement.​

Using NPS and mutual funds together

The strongest retirement plans now combine NPS’s low‑cost, tax‑efficient accumulation with the flexibility and product breadth of mutual funds for both pre‑ and post‑retirement phases.​​

During working years

• Use diversified equity mutual funds (flexi‑cap plus some mid‑cap or small‑cap exposure) as the primary growth engine for long‑term goals, including retirement.​​
• Treat NPS as a supporting pillar, maximising employer contributions and using personal contributions mainly to the extent that tax deductions genuinely improve post‑tax returns under your chosen tax regime.​​
• Keep debt exposure (EPF, PPF, high‑quality debt funds) calibrated so that overall equity allocation matches your risk capacity, not just your risk appetite.​​

Videos like How should I plan my retirement? and How can I build up a sufficient retirement corpus? can help investors translate this framework into an actionable plan.​

At and after retirement

Historically, a key weakness of NPS has been the requirement to lock at least part of the corpus into an annuity, often offering modest, fully taxable nominal returns that may not keep up with inflation. The newer rules around higher lump‑sum thresholds and SUR now allow more nuanced strategies.​​

Here’s a practical approach:

• Aim to keep the total corpus at normal exit comfortably above the small‑corpus thresholds so that you can use the standard framework (higher lump sum plus annuity) rather than relying purely on the Rs 8 lakh ‘full withdrawal’ limit.​
• Use NPS lump sum (up to 60-80 per cent, depending on rules applicable to your subscriber category and corpus size) to seed a conservative–moderate mutual fund ‘income portfolio’ (typically a mix of short‑duration or banking & PSU debt funds plus some equity/hybrid exposure) that can sustain a systematic withdrawal plan (SWP).​​
• Keep the mandatory annuity portion as a ‘floor’ income stream, recognising that its role is capital‑protection and longevity insurance rather than return maximisation.​
• Use SUR where available to phase NPS unit redemptions in a way that complements mutual‑fund SWPs, smoothing cashflows and reducing timing risk.​

Value Research’s content on retirement income, such as How can I generate regular income in a tax‑efficient way? and Retirement tips to beat inflation and improve returns, provides further guidance on building sustainable drawdown plans.​

Cost vs risk: Where each side clearly wins

The key comparison points between NPS and mutual funds remain the same, though the context around returns, tax and exit rules keeps evolving.​​

Cost

• NPS continues to be structurally cheaper than most equity mutual funds because of regulated low fund‑management charges and the absence of distributor commissions within the core pension structure.​​
• For pure cost efficiency in a tax‑advantaged wrapper, NPS has the edge; but for flexibility and potentially higher net returns, especially via mid‑/small‑cap exposure, equity mutual funds justify their higher TER.​​

Risk/return

• NPS equity options, with their large‑cap bias and equity cap, generally show lower volatility and somewhat lower long‑term return potential than aggressive equity mutual funds.​​
• Mutual funds can take more style and market‑cap risk and therefore can both outperform and underperform more dramatically in different cycles, requiring greater discipline from investors.​

Liquidity and control

• Mutual funds offer near‑full liquidity and easy rebalancing across schemes and asset classes.
• NPS (Tier I) still has binding constraints: early‑exit conditions, annuity requirements and limited switching flexibility relative to an open mutual‑fund platform, even after the recent rule relaxations.​​

For investors specifically comparing NPS Tier II to mutual funds, read Comparing large‑cap and debt funds with NPS Tier 2.​

So, which should you prioritise now?

The evidence, including current performance and regulatory changes, supports a nuanced conclusion rather than a simple ‘either‑or’.​​

• For corpus building, long‑term equity mutual funds (with a sensible asset‑allocation plan and periodic rebalancing) should remain the core of your retirement strategy, especially if you expect to use the new tax regime where NPS’s tax edge is muted.​
• NPS works best as a complement, not a substitute:
  • Maximise employer contributions wherever available.
  • Use personal NPS contributions primarily to capture genuine incremental tax benefits under the old regime, within a calibrated allocation.
  • Treat the NPS annuity as a safety net, not your only source of retirement income.​​

For most investors, a robust, practical rule of thumb is: build the bulk of your retirement wealth through diversified equity mutual funds and EPF/PPF‑type instruments and use NPS as a disciplined, low‑cost adjunct that provides tax relief where it truly applies and a modest guaranteed‑income floor in retirement.

Also read: NPS gets an upgrade

This article was originally published on April 22, 2024, and last updated on January 20, 2026.