The first part refers to setting a "default text encoding". The actual drop down box at /editinfo.bml is named "Auto-translate older entries from:", under the Encoding Options heading.
Either the wording on editinfo.bml could be changed to something like "Auto-translate older entries from: (default text encoding)", or the FAQ wording could be changed to something like:
To do this, first visit your Personal Info settings at http://www.livejournal.com/editinfo.bml . Scroll down to the bottom and choose to auto translate your old entries from the appropriate encoding. [this is explained further in the following paragraph]