it encrypts the data in that location. this will be pretty much the norm, and on a hardware basis, in storage in the very near future. What this means is that without the key the data will be unreadable. The good side is if your storage device is stolen the data is secure, the downside is if you say.. lost that key.. it's unreadable for you too
I believe there is that warning in the preference pane though.
Now that all being said, I don't have any idea how Apple, specifically, incorporates encryption. But I can answer general questions regarding how the base technology works.
Should you be using it? Don't know, I don't bother. Well, at least not at the moment, I probably should though I have some source I should protect