I was wondering this myself. My take would be that the city would become a settlement even if there are no pieces- "Pillaged cities are reduced to mere settlements" Though the rules to refer to "losing a city" in a couple places, they offer no other definitions as to what losing a city means.
I would suggest turning it upside-down (not sideways, to keep it separate from sabotaged cities) or using some other token and treating it like a sixth settlement. Of course, if a city is built in a different location, replace it with the proper settlement piece.
The only other option I could think of is that perhaps, like a person with no cities or a person with only a metropolis, they are not eligible to pillaged. This one doesn't sit right with me, though, because they're neither so pathetic as to not be able to be pillaged nor have they earned the right not to be.
Your way doesn't sit right with me either. Losing two points (and more importantly, in my mind, two spots worth of production) when everybody else only was up to losing one seems greatly unfair.