Last Updated on May 25, 2022 by Neera Bhardwaj

Retirement planning involves preparing to meet the cost of living and continuing to live comfortably at a time when there is no steady flow of income in the form of salary. Therefore, it becomes necessary to save up money during the earning yrs to enjoy a post-retirement life. Now, when we talk about long-term investments such as retirement, the two most popular avenues among investors in India are the National Pension Scheme (NPS) and Systematic Investment Plan (SIP) in mutual funds. In this article, we cover the benefits of NPS and SIP in MF and their differences.

About the National Pension Scheme (NPS)

The National Pension Scheme (NPS) is a retirement-focused savings scheme initiated by the Government to encourage salaried individuals to invest for their retirement. It is a tremendously flexible product, however, far too many options also tend to confuse investors. That is the main drawback of NPS, that it is perceived as a complex instrument.

In essence, subscribers to NPS may contribute regularly in a pension account during their working years, and withdraw a part as a lump sum upon retirement at the age of 60. The remainder is used to buy annuities that will provide a regular flow of income during the retirement period. 

The funds contributed in the NPS are invested by the Pension Fund Regulatory and Development Authority’s (PFRDA) authorised pension fund managers. Currently, there are eight managers. The number of fund managers gets updated from time to time. The investments under the scheme are a judicious mix of Government securities, equities and bonds based on the option of the account holder, with age as the primary determinant of the risk factor of the subscriber. Someone in their 30’s may be able to allocate 90% of their contributions to equity, however, this comes down automatically to 45-50% as the subscriber nears retirement age. The portfolio of someone in their 60’s would have more debt allocation than equity, in line with the perceived risk appetite of the subscriber.

The accumulated wealth depends on the value of the contributions made and the gains from the investments. The longer the term, the greater would be the benefit of the accumulated pension. When you open an NPS account, you will be provided with a Permanent Retirement Account Number (PRAN), which becomes your unique identification number as long as you hold the account.

The NPS scheme is structured in two tiers: 

  • Tier I:  It is a mandatory account and non-withdrawable NPS account that can be redeemed only upon meeting the exit conditions framed by the government under the scheme – attaining 60 yrs. Under Section 80 CCD, this account is eligible for an additional tax deduction of Rs 50,000, over and above the 80C contributions.
  • Tier II: You can subscribe to this withdrawable NPS scheme only if you have an active Tier I NPS scheme in your name. You can withdraw an amount from this scheme as and when required. This account does not have any tax benefits.

You can choose different fund managers and asset allocation options for your Tier I and Tier II accounts.

Benefits of National Pension Scheme (NPS)

Selective contribution

Subscribers to the National Pension Scheme have the flexibility to choose the investment amount. You can increase or decrease the annual investment amount as per the availability of funds at your end.

Low risk

The judicious mix of investment instruments in the scheme helps with portfolio diversification, significantly reducing the risk exposure of the subscriber’s contributions. The equity exposure depends on the choice of the contributor for investments and not all schemes have the same level of equity exposure.

Flexible

NPS offers a plethora of investment options and pension funds you can choose from. You can switch from one investment option to another or from one fund manager to another without any hassle.

Transparency

It is regulated by the Pension Fund Regulatory and Development Authority (PFRDA). They ensure that the investment products are taken care of by the fund managers and the transparency is maintained.

Taxation

This is the greatest attraction of NPS. Investments in NPS are liable for an additional Rs 50,000 claim from taxable income above the Rs 1.5 lakh provided by Section 80C of the Income Tax Act. This makes NPS a very tax-efficient pension product.

About SIP mutual funds

Mutual funds are one of the most popular investment products, especially for investors seeking indirect equity exposure. Retail participation in mutual funds has increased exponentially over the years, majorly because of the flexibility provided by the SIP feature. 

The SIP method makes it convenient for investors to gain exposure to equity at a minimal cost and attempt to gain decent returns. It makes for disciplined investing and is automated, making it a hassle-free process for investors. Under SIP, the money is debited automatically from the bank account on the date and the frequency chosen by the investor.

Benefits of SIP in mutual funds

Compounding

It is a long-term game, therefore, returns from mutual funds are better when you stay invested in the markets for a longer period. The capital undergoes appreciation over the years, which helps in wealth creation. Also, if you invest in dividend mutual funds, you have an option of reinvesting the dividend income. This helps accumulate augmented returns in the market.

Small size investment

SIP enables investors to explore various assets through pocket-friendly investments in mutual funds. An investor may set up a SIP for as low as Rs 500, generally.

Investor discipline

SIP creates investing discipline in an individual, and if started young, it can prove to be very fruitful in the long run.

Potential higher returns

Most mutual funds use the benchmark indices as a base and try to outperform the market to return a higher profit to its investors than the index. So there is a potential for greater returns, should the mutual fund manage to achieve its objective. This is however accompanied by market-related risks as well as additional costs towards fund management.

Cost averaging

The best part about long-term investing via SIP is that a dip or correction in the market is a good opportunity for you to average down your buying price. SIP helps protect your investment against market volatility.

Working of NPS vs mutual funds

NPS vs mutual funds is a difficult comparison as the working of both the financial instruments is dissimilar. Both of these funds are however actively managed by fund managers. 

NPS comes with options of auto choice – Lifecycle Fund and Active Choice. Auto choice is a default option for an NPS account if the account holder does not want to choose the investment instruments for the scheme. 

While talking about asset allocation, many equity mutual funds offer a higher exposure to equity when compared to NPS which affects the overall return.

Who can invest in NPS and mutual funds via SIP

Investors who want to invest in the financial markets for a longer time frame can consider investing in NPS or mutual funds. Also, these are the best options suitable for salaried professionals who have a lower-risk appetite and want to save money for their retirement. Both NPS and mutual funds are eligible for tax deductions under Section 80C of the Income Tax Act of 1961. However, NPS offers a slight advantage over mutual funds as apart from the Rs 1.5 lakh tax benefit, NPS offers an additional benefit of Rs 50,000 under Subsection 80 CCD (1B) of the IT Act, 1961. 

Mutual funds are more flexible when compared to NPS as a lock-in period does not generally apply, except for ELSS funds where it is a short three years. Meantime, NPS allows withdrawals only after the individual is 60 yrs of age. When it comes to returns, mutual funds again have a probable upper hand, but this is accompanied by higher risk.

How to invest in NPS and mutual funds?

You do not need a demat account to invest in NPS or mutual funds. Both of them can be allocated in your portfolio without opening a demat account. You can open an NPS account within half an hour by just logging into the NSDL website. After selecting the eNPS tab, you have to upload your KYC documents along with salary slips. Once the documents are uploaded and verified from the backend, you are all set to start your NPS investment. You may also directly visit the NPS website and fill out the application form.

While it is not compulsory to have a demat account for investing in mutual funds, you may invest in mutual funds through a demat account too. As far as SIPs are concerned, you do not need a demat account unless you buy the fund from the stock exchange via a broker. Alternatively, you can start a SIP by directly opening an account with the fund house.

Key differences between NPS vs SIP in mutual fund

Parameters NPS Mutual fund SIP
Returns The average return offered under NPS is variable and generally decreases with increasing age of the subscriberIn mutual funds, investors can earn potentially good market-related returns, provided a long investment period
Lock-in periodThe lock-in period is usually higher in NPS as it’s a predominantly retirement plan. Therefore, the lock-in is also till retirementIn the majority of mutual funds, there is no lock-in period. You can redeem your capital whenever you want. However, ELSS funds have a lock-in period of three years
Tax benefits Investors enjoy tax exemption up to Rs 1.5 lakh. Additional tax benefit of Rs 50,000 is also availableOnly under the ELSS scheme, investors can take tax benefits up to Rs 1.5 lakh  
Risk exposureThe NPS funds have less exposure to the equity market with increasing age of subscriber, therefore, the risk is lowerMost funds have a high equity component, thus, the risk level is higher 
Pre-withdrawal Investors can withdraw only up to 20% of the amount before retirement Mutual fund investments do not have such a clause; you can redeem your investment whenever you want
Income tax NPS is an EET investment – the corpus you withdraw at the time of retirement is taxableInvestors need to pay short-term capital gain tax or long-term capital gain tax on the capital gain 

Risk vs return in case of NPS and mutual fund investment via SIP

Both NPS and mutual funds are multi-asset products with the potential to generate good returns. With NPS, the asset allocation mix of equity to debt ratio decreases with increasing age of the subscriber. While it may even 90:10 during the initial days, by the time the subscriber is 50 yrs, the ratio falls to 75:25, and thereafter further reduces to 50:50. The risk is managed very well here, however, at the cost of returns.

There are no such limitations for mutual fund investments. Mutual funds can allocate their funds into any asset they deem appropriate according to the objective of the fund. Therefore, high-risk mutual funds have the potential to generate more returns than NPS.

Which investment method between NPS vs SIP is better?

This depends upon the financial goal of an investor and also on the risk appetite of the individual. If you are ready to invest a specific amount regularly for the long term but fear market volatility, a SIP in mutual funds may be suited better. However, should your goal be retirement planning and you are someone easily influenced by the market noise, NPS may provide you with the lock-in you may require to keep your funds at bay and allow it time to grow into a large corpus for your retirement use. The best way, nonetheless, is to have both in the portfolio. Speak with your financial manager to find the suitability of the products to your portfolio before investing.

There is merit in both – NPS, as well as mutual fund investments via SIP, to generate wealth over time. NPS provides stability whereas mutual funds provide growth. If you are an aggressive investor, you can choose to allocate more funds to mutual funds whereas if you are a conservative investor, NPS can carry a higher weightage in your portfolio. It is important that you get an understanding of your risk appetite before investing in either of these financial instruments.