My thoughts on the matter is that hand to hand needs to go away. It really has no purpose in this type of fantasy world. As the other guys pointed out, punching a Storm Antrinoch or a guy in iron armor would do more damage to yourself than to your foe.
If you MUST keep it around, make it realistic like that! If you do an unarmed strong attack on a fully armored foe, it actually hurts you instead of them! But then you could balance it out by making it super-effective on "soft" targets like a sleeping guard or a wizard in a robe. Make it so you have a chance to paralyse, knock someone out cold, or do some kind of sick "finishing move" like a neck snap or crushing windpipe. make it so you can take an enemy's weapon out of their hands and use it on the fly. Wow, now I'm starting to reconsider taking it out.
If you MUST keep it around, make it realistic like that! If you do an unarmed strong attack on a fully armored foe, it actually hurts you instead of them! But then you could balance it out by making it super-effective on "soft" targets like a sleeping guard or a wizard in a robe. Make it so you have a chance to paralyse, knock someone out cold, or do some kind of sick "finishing move" like a neck snap or crushing windpipe. make it so you can take an enemy's weapon out of their hands and use it on the fly. Wow, now I'm starting to reconsider taking it out.
Here's a couple of reasons Hand to Hand should not be taken out:
http://www.youtube.com/watch?v=4DLY4OXVrSw&feature=related
http://www.youtube.com/watch?v=90_bXmEOTyQ
As far as armor goes: Yes, armor can really help, but most of the damage is caused by concussion. Kicks would be especially good for this. A good front or side kick could send an opponent a few yards away, even with heavy plate armor. That in itself would do some major damage.
I think another thing that would help is an improved defense system; dodges and parrying. Until recently, I didn't realize just how effective a parry can be. While sparring a couple of weeks ago, I parried one punch and ended up getting a kidney shot in. It's because the force of his punch and his momentum forward allowed him to pass right by me. Swords and heavy armor would be much more prone to this. While powerful, they risk having their power used against them.