Sorry, I am confused - are the houses already up? Or is this something that is going to happen? Just trying to get the timescales straight in my head and to understand why there are no areas for 'meaningful screening' if that was recommended.
From your diagram, I can really see the issues you face and why you are upset!
I like your idea of a border with varied heights in it. I would have a really good, hard think about where the screening is that I'd need - and that's partly about which of their spaces are heavily used, and partly about where you need privacy. I probably wouldn't worry too much about a landing window, for instance, as it's unlikely anyone will be up there for long - but I would worry more about a bedroom, for example. It's not a question of not having screening, but of getting the absolute most out of the height where you do place it.
Along with screening, there's also a kind of tricking of the eye that happens with good design: something bright and attractive in the right place can simply draw attention away from ugly areas. It's not privacy that this produces, but a kind of psychological effect of it, if that makes sense. A good shape to a border will help with this - one that perhaps protrudes out towards the house in places and retreats back in others. I think your plan of a retaining wall is a very smart one - I did this in my garden as a way of levelling a slope, and it really has worked well. I constructed it cheaply out of buttressed breeze block and then faced it in stone - worked out way cheaper than brick. For what you are doing, you wouldn't even really have to think about facing, because you're not going to see it!
Also, if you can stand it for a bit, some trees grow really quite quickly! This can save £££ if money is an issue. For example, a planting of three or five of the very white birch, Betula jacquemontii, will shoot up in no time and give you deciduous cover, plus a focal point that draws the eye in the winter. In fact, a lot of people plant these for a short time (15-25 years) with the intention of getting rid and replacing (this keeps the trunks really white and pure).
On a positive note, I also think you sort of get used to protecting each other's privacy after a bit - the front of my house is quite overlooked, and the neighbour across and I will sometimes catch one another's eye across lounges and wave, and then studiously go back to pretending we can't see each other at all
. Hopefully your neighbours will be equally pleasant, which might go some way towards making you feel better about what sounds like a really difficult decision to deal with. 