A.M.
S. - I am sure you will get many different responses to your question because everyone has their own beliefs and ways of handling their children.
If these were my children I would step in each time as I feel that is my job. The younger one needs to be 'punished' in whatever that means to you - 2 minutes in time out, spanking, etc. everytime she does something wrong. The 5 year olds reaction is instinct and unfortunately drives your younger one to want to do it more. It is difficult to explain to a child that ignoring it will make them stop doing it - and 99% of the time you can't get this idea to play out.
Although I wouldn't punish my 5 year old for pulling the younger ones hair back, I wouldn't encourage it either. This will only cause problems at school as most children caught doing something wrong was a reaction to what another kid did to them (and got away with b/c the teacher didn't see). You have to come up with a way to teach the younger one that what she is doing is wrong. Use different methods to find out what makes your younger one react and then use it! In addition, many parents make the fatal mistake of saying, "I'll deal with it later" because they are in public - If you wait even 5 minutes later your child won't understand that they are in trouble for something they did 5 minutes ago. You have to stop and deal with it now. So punishments such as going to bed earlier or not getting a popsicle after dinner don't work.
You might think some of my methods and examples are for older children but I can tell you that 1 year olds understand more than we think they do. I have a 2 year old who from 8 months old understood right from wrong (I didn't realize it at the time but then I noticed he would look around to make sure no one was looking just before doing something he knew he shouldn't do).
My bottomline recommendation is to stop it when it happens, discipline your 1 year old, explain why she is being disciplined, repeat this everytime it happens.