Yes, i believe this is by design, to prevent "neutral" cities from growing/building and increasing their area of influence - since they are meant to be "minor" factions and not "major" (playable) factions.
As mentioned, razing them is generally the best choice. Trading them a thousand materials for their gildar before assimilating their faction would be an even better choice.
Another option is to engulf their area within your area of influence... making it so you are the only faction able to reach their territory (short of people at war with you, or non aggressive with you). The purpose of this is to have a faction you can always develop trade and tech treaties with for a very low cost - usually recouped in a handful of turns. By engulfing them, you prevent other factions from wiping them out. They also serve as a bank of sorts, since they generally have about 1000 gildar and no other resources whatsoever, making for an easy trade.
