Announcing the cabinet decision, finance minister P Chidambaram said the new legislation would empower the Pension Fund Regulatory and Development Authority to appoint pension fund managers.
Asked if the legislation would be introduced in the winter session of Parliament, he said it was for the cabinet committee on parliamentary affairs to decide.
The proposed legislation would also lay down guidelines on the number of players, prudential norms, investment criteria and the capital requirement for the fund houses.
The cabinet's approval to the proposal of the finance ministry comes in the wake of mounting pension liabilities of the central and state governments.
Indications are that there would be only "limited" number of pension fund managers, of which at least one would be from the public sector.
The government is also expected to consider allowing foreign direct investment in the sector. However, Chidambaram said this issue was not discussed in Thursday's meeting.
At present, there is an interim pension regulator, which was set up by the previous national democratic alliance regime.