How does retirement work?

Items you or your friends pass on can be found as loot in other ships, usually from crates. Whether you can make any significant changes to the overall loot quality is debatable (though everyone I know would have problems with this- some idiot keeps naming wrenches Wrenchy McWrenchface).

As mmathews' commented, the main reason to retire characters is to get rid of them once the penalties kick in. As characters become more famous, they become less effective at earning liberation progress. Once they've done their Personal Mission, you're often better off getting rid of them.

Inheriting items gives you a nice reminder of that character. It's fun to think "this isn't just an automatic shotgun- this is the shotgun Zero Gemini used to go on a rampage after he killed his wife by accident".

You can also inherit friends' items and they can inherit yours. You can have a lot of fun giving items funny names like Wrenchy McWrenchface and seeing your friends' reactions.