NPS Tier 2 vs Hybrid funds: Which is more suitable for you?

We know that the National Pension Scheme (NPS) Tier 1 is a popular option for retirement saving. (In fact, we recently compared it to mutual funds in our October Mutual Fund Insight edition .)

However, on an anecdotal level, fewer people are aware that NPS has another side to it: NPS Tier-2. It functions like a mutual fund , offering greater withdrawal flexibility than NPS Tier 1.

So, when a user recently asked us which is better - hybrid funds or NPS Tier 2 - we decided to dive deep to find an appropriate answer.

But before we evaluate their performance and quality, let us quickly compare the two.

Performance Comparison

Equity portfolio

We created two hypothetical NPS Tier 2 portfolios: aggressive and conservative.

An aggressive NPS portfolio was created through the 'active' option so we could directly compare them with aggressive hybrid funds.

Similarly, a conservative portfolio was made to pit it against conservative hybrid funds.

Here's what we found:

i) The NPS Tier 2's aggressive portfolio had a roughly similar pre-tax performance with aggressive hybrid funds , based on daily five-year rolling returns from January 1, 2018, to August 28, 2024.

However, aggressive hybrid funds are clearly ahead in their post-tax returns. That's because aggressive hybrid funds are taxed 12.5 per cent beyond the 1.25 lakh exemption, while the NPS aggressive scheme would be taxed at the applicable tax slab rate. So, if your total income falls in the highest tax slab, you end up paying a steep 30 per cent tax on NPS Tier 2 gains.

ii) The NPS conservative portfolio, meanwhile, consistently outperformed conservative hybrid funds over the same period. Since both are taxed similarly, their post-tax returns showed no difference.

Debt portfolio

The debt side of hybrid and conservative schemes revealed the following aspects:

• Yield to maturity: The YTM (read interest) of NPS schemes and hybrid schemes are in the same ballpark and, thus, do not lead to any conclusions.
  
• Duration: Duration measures the sensitivity of a bond to interest rate changes. A longer duration means higher sensitivity (read volatility) to interest rate changes.
  The duration of NPS schemes C (corporate bonds) and G (government bonds) are longer (4.95 and 9.09, respectively) than aggressive and conservative hybrid schemes (3.65 and 3.96, respectively). In other words, NPS Tier 2's debt portion can be more volatile.
  
• Credit quality: They are almost at par. More than 90 per cent of their debt portfolio is in securities rated AA+ and above.

Our take

Your investment goals and risk tolerance are crucial when deciding between NPS Tier 2 and hybrid funds. Let's break it down based on equity or debt focus:

Equity-focused

• Choose aggressive hybrid funds as their post-tax returns significantly outperform those of NPS aggressive portfolio.
  
• Aggressive hybrid funds are taxed 12.5 per cent on long-term capital gains, while NPS Tier 2 withdrawals face slab rates, potentially up to 30 per cent.

Debt-focused

• Opt for NPS conservative portfolio as it outperforms conservative hybrid funds.
  
• However, do note that the former will be more volatile due to its high duration. Therefore, your investments may face higher volatility.

For investors with a long-term horizon seeking higher growth potential, we recommend considering flexi cap funds . These funds have the flexibility to invest across market capitalisations, including mid and small-cap stocks that often offer higher growth potential over the long run.

Also read: Calculating UPS pension and NPS retirement corpus