OP, I agree with your assessment, just get them a phone. I highly recommend going the used route for this purpose. If you want something with a bigger screen, don't spend a bunch of money on any tablet! Just get an older phone with a big screen, it's still going to look huge next to iPod. Ones to look at that will be cheap now are some of the older Evo's. Heck, the Evo 3D would surely keep the kids entertained and wow their iPod friends. If you buy from someone that used a case and screen protector, like I do, their used phones will look nearly new.
Secondary topic below:
If your kids want an iPod Touch, get them an iPod Touch. If that's what they want, keep them happy.
And that's how you raise a child to be entitled. The OP is the one with the money, it his up to his discretion to get what is best for their situation. If kids knew what was best for them, they wouldn't need parents.