There were so many times that I've seen an NPC saying I was going to die. So if I let myself be defeated, that means the NPC is dumb enough to not finish killing me and letting me retreat? The OP talks about "realistic", but that doesn't sound "realistic" either. How that after a NPC threatens to kill me, they just let me escape that easilly after he "defeats" me... Nah.
And mobs have morale, at first you were talking about mobs, not creeps, and here the proof they have morale: Joego scored a hit with Call to Fate on Ilzkâl the Pummeler for 3,272 Light damage to [b]Morale[\b].
In some games, you have to save your game and if you die eventually, you'll go back to where you were the last time you saved. LOTRO is not like that, so when you get killed, instead you'll get teleported to a Rally Circle.
The ability to go to the past in the game is present in almost everything. When you let Legolas die in a quest, you can go back to that quest later and start over. Or the ability of doing an instance many times...
I believe 99% of the times we are defeated by enemies we are killed. Simply because I don't think our enemies are fools enough to defeat us and not finish killing us. If you try to find a realistic reason for most things in the game, you'll find many conflicting things.
Like you said "I don't think our characters die. That's why they use Retreat and not Respawn". Why do I have the option to retreat even when I get incapacited by misadventure?
And you said "we retreat to the nearest Rally Circle to gather ourselves.". So let's say I am doing an instance in a room with my friend and every gate in the room is closed so there is no way I can escape from that room. Then I die and my friend survives, but still I get teleported outside that room while my friend stays in the room with the boss and the gate is still closed, so I can't come back to the room. How can you explain that realistically? Maybe they can pass through solid matter like Kitty Pryde from X-men and gather themselves outside of that room?
That's my point: you will find conflicts if you try to find a realistic reason for everything.