The traditional way of handling PC death in AD&D is for the player to roll up a new, 1st-level character. The bite of death is strong in AD&D, and the intention is that players treat the risks of adventuring very seriously.

However, what is traditional isn't universal—plenty of groups made up their own table rules for how to make a character after an advanced one died. You're well within your rights to say that they start with half their old PC's experience, or one level less than the lowest other party member, or at the average XP of the party minus 1000, or whatever simple or complex variation you can think up.

One of the things to keep in mind while considering how you want to handle this is that mixed-level parties not only work fine in AD&D, but they are expected. The power curve in AD&D is much flatter than in recent editions, making the difference between a 5th-level character and a 1st-level character much less than modern players might assume. With less power divergence, there is less mechanical pressure to ensure that levels are the same—so that should not be something you worry about when deciding how to handle new PCs joining an advanced party. Furthermore, because XP is split evenly among everyone who survives an adventure, any lower-level members of a party will advance slightly faster than normal, since their party will generally be taking on greater challenges—this makes the power difference even less of an issue than it already is.

Basically, history and I give you permission to handle this how you feel is right—there is almost no way you can handle it wrong. If you feel that the organic development of a character from 1st level is important, then you're in agreement with a lot of present and past AD&D gamers, and you should do that.

I think the hat of disguise is a wonderful heirloom to start the game with. It promotes roleplaying and fascinating non-combat interactions. In my games I would expect characters to take one of five routes:

1. All characters can get an equivalent non-combat magic item of about that cost given a backstory. Then, if they want an item, they can go to equivalent effort and their choice is respected.

2. You may want to allow each player to nominate a book to involve in the game. In this player's choice, it should be the Tome of Magic. I've played a social binder (equivalent to a gent with a hat of disguise) at early levels for precisely this reason. The character may want to dip into Binder, because at level 1, he gets access to Naberius, which gives benefit to social skills as well as the ability to disguise self at will. It sounds like it fits his intentions perfectly, and there are a number of other capabilities that would benefit him neatly.

3. House rule a feat (due to the paucity of sources. Otherwise I'd use one of the extant ones) to provide disguise self once or three times per day, as per a caster level of the character's level. There are plenty of better things to do with a feat, but disguise self could be worth it to a sufficiently motivated character.

4. Invest heavily in the disguise skill, and some masterwork elves ears. While it's not as exciting as a full on disguise spell, bluff, forgery, and disguise do form the basis of the Rogue's repertoire for good reason. Disguising oneself as another race is a -2 on the check, which can be easily countered by the underwhelming deceitful feat.

5. The character starts out as a sorcerer, knowing disguise self and silent image. Using the fluff that "the magic's in the blood" it's quite plausible that he was casting spells in the crib. The rest of his levels can be rogue, flavoured with just that hint of the "alien, uncontrolled magic that is his heritage"