> Having a (targeted, scope and time-limited) design discussion or giving your candidate some made-up context around an engineering cycle and then doing a retrospective with them

You just described a contrived, “unreal” problem.

> I'm also not sure what the alternative is? Just not hiring?

The alternative is to come up with questions that are representative of skills related to “real problems”, as you just did, and use those instead. Unfortunately candidates consistently complain that such questions aren’t realistic.