Honestly I think that because of the fact that we are projecting our awareness outwards (already in an illusory reality), we don't really have an understanding of what lies behind our consciousness, so all of our insights relate to identity as we know it.
I think this is very important thought, and while it may be not necessary always true, it's generally our situation here. Why it's not 100% correct? Since nobody is stopping you to go inwards, explore how you feel, who you really are. However, this is far from "normal behavior". It's not in our "program", not our "life goal". On the contrary, it leads mostly to depression, melancholy, since what you really are, is not present there. And IMO, this is the "key" to actually going beyond that experience. Detaching from the false image of yourself, and from this kind of life with sole purpose of project outwards.
On the topic, which is "more" correct, I tend towards the second one. The reason is this. I don't believe that the creator is separate from its creation. We even say, that one put "his soul" into something. What it really means? Well, it means that the Source spawned creators, that spawned lesser creators, and so on, and so on. I doubt the idea for this world was to degrade, but this is very possible, probably even immanent. It's dream withing a dream within a dream... To what purpose? I doubt we can talk about "purpose" on that level, but there is an end, and it looks to me, it's the creator realizing its creation. So there is really something in life, a process to become more and more self aware. However, using terms like "evolution" is major misconception what is the scientific meaning of this term (most people don't really know it). It's also a major misconception to imagine "unlimited possibilities" and fairy tales... Often, you get aware that what you did was actually wrong, flawed, so on. Why do you assume this creator is perfect? So working with the proper terms is good starting position. Don't try to "evolve", try to be more aware about life... Don't think about yourself, as something somehow "detached". The creator himself is bound by its creation.
Will life degrade? Well, if we return to the first point. Life is just realization of its creator. It's as bad as this creator, and through realization of the mistakes, we get better understanding. So in some way, life is on the level it's supposed to be. However, it seems that life becomes more and more machinery with time. The modern society, instead of getting less programmed, actually becomes more programmed. Going full speed towards social engineering, AI, creating a life you really don't want to experience... While I doubt this was part of the original plan, this is how this universe will probably end... ruled by AI overlord. IMO, the fear is real. We were created so weak, in so physical world, and the attempts of the most to overcome their limited nature, will end into more or less annihilation of the natural life, and something even worse. In that specific sense, I agree with Angeliki.
Otherwise, the difficult question is, what must happen for the creator of this world to realize it's mistakes? How many must wake up? And since this creator is part of another creator, but not really totally separate prison, is it possible just part of it to wake up? I.e. this is the other classic dispute "we" vs "I". Personally, I don't believe in "we" (at least any more), and this looks like how the game was designed. The game is all about fragmentation, separation, gaining your unique perspective about "life", paying the price... Was this and "error"? Who I am to judge, but you can't go 180 degree and say stuff like "we are all one". Here, no, we are not. In another realm, maybe, but getting there is by the rules of this game...
Do plants and animals have the same level of consciousness like us? Can they achieve higher awareness like us, and get out of here as "individual souls"? I have no idea, but it should not change the way we treat them, since they are sentinel beings like us, and take part in the same play like us. The way we treat them, shows the way we treat ourselves.
"They have the reincarnation belief that all of creation, goes through karma of upward or downward rewards or punishments, so you could be stepping on a relative or such."
There is a lot of misconception what Karma is. While you live, you are under the rules of Karma, which is basically - actions and consequences. Karma has nothing to do with moral, or the absolute. However, Karma, by definition exists in a casual world. Even the creator of this world is under such rule, since it imposes it on itself. And through the creator - the creation. To get out of Karma, you can deny the creation. There are again, two visions:
1) that we have so much more to learn, "evolve"
2) that we know everything and 1) is just a lie
IMO, both are wrong.
1) is very vague, what exactly we learn? The third law of Newton? I don't think it's that complicated... How many lives do we need to get it? This category people try to put in this moral justice ideas, mysticism, which are simply not true. Karma is just causality, nothing more... It can't make you "a better person" by itself. Also, since it's so easy here, many become kings of deception, and avoid causality... It's also part of the game to be aware of the lies. Like the saying: fool me once, shame on you, fool me twice, shame on me.
2) how this world happened then? If the Source was really that "all knowing" how it created so flawed world? And the truth is, even full/perfect awareness doesn't mean "all knowing, all understanding". This would make its existence dull. It creates games with different rules, different limitations, and experience them from different view points. Did anyone got born knowing how to be a human? I don't think so... Again, it's completely different topic, whether what you "learned" can be called "good". It's hard for people to not put absolute "good" vs "bad" values, but on that level, it's not possible. It's common sense, that on the level of the pure awareness, there is no "good" and "bad". However, when you start playing these mind games, are you sure there is no differentiation between true and false, good and bad?
And this is the other mistake, trying to say that because there is no good/bad on the level of pure awareness, good/bad are just an illusion... Well, you are also just an illusion, so... what that even means? It's a lot like physics vs quantum physics, rules change, you must not try to apply rules from the one side of the veil, to other one... It doesn't work that way.
Actually our game here, is very much a question on this topic. Is life fair? Is something wrong with getting born as a warm? Or a chicken? Or a human? These question IMO, only a "person" can answer. You can call the "person" an illusion. The pure awareness is not a "person" right... But at the same time, this is form of awareness, that perceives the world of illusion from a particular view point. Yes, limited, but also based on actual experience. For us, the "person" is the most developed form of awareness we know in this world of illusion. I know, most religions and teachings, don't believe much in being a person. Christianity says you are fallen, despicable. Buddhism says the self is just an illusion and you are nobody. Islam says you were created just to serve Allah, but Allah doesn't even need you... And, it's a fact, most people don't really have personality, there is something that is more like the individuality you will find in an animal. But still, there is something there, and at least I believe, with the process of life you discover "it". What is this "it", is a difficult question, but in order for "it" to appear from the pure awareness, something must happen. And this something is "life". I have a favorite movie called "Dark City", where aliens experimented with humans, by changing their life conditions (i.e. fake personalities), and clearing their memory, in order to see, what is the "soul", i.e. - what persist in the human beyond the causality. IMO, more philosophy there, then you will get from most religions... Anyway, there is something like this, that Kant calls "The Good Will". This is what you base in your own soul, it's not based on your body. For him, this is the real definition of morality, and the only possible definition of the term "free will". If it's not obvious why - if your choice is based on causality, it's no longer free. If your choice is self-evident, it's "free", but no longer choice. So the only setup to have "free choice" is causality not related to morality (which is the deeper explanation why Karma is not moral).
And I fully agree with him. Btw, people like Kant/Schopenhauer are way beyond these two authors in their understanding, but sadly most modern people read only contemporary literature... What I'm trying to say is, even if Karma is artificial, even if there is nothing to "learn"(in the way most people imagine it), this doesn't mean you are really "free", and you made that "choice". Becoming "free" of the game is complicated process that requires to question who you are, and who created this world. Part of this creator is in you, still trying to realize its creation. So you must answer the questions of this creation. There is no right or wrong answers I guess, just whether you have the required understanding or not. Who can really reach this level of understanding is a tough question. Can we even as humans reach it? Or it's just mind games, overestimation, still just projections coming from outwards... IMO, in any case, we can at least question this, and see what the limits are. Seeing the actual limits of this life, is a form of understanding.