IMO they could have two separate slots, one for the stats/armor you have equipped and then another that you can put armor into for vanity and display it instead of the actual "equipped" armor in said slot.
This still keeps people getting new gear (better gear) but it still allows them to keep any "look" they want for any equippable slot.
To balance it out you can just make it where it can only be used with the same type, so if you are wearing heavy armor in those slots, you have to wear heavy armor in the vanity slot, if you are wearing light, you have to wear light, etc.
That way you won't get "light armor" looking people who are wearing heavy armor and you are left wondering "why on earth are they so tough!"