You are probably getting this error because the account password isn’t in reversibly encrypted form. In order for the setting to become effective, the password on the account needs to be reset. The new password will then be reversibly encrypted. From the documentation for CHAP: “When you enable passwords to be stored in a reversibly encrypted form, the current passwords are not in a reversibly encrypted form and are not automatically changed. You must either reset user passwords or set user passwords to be changed the next time each user logs on.”
There is nothing unsafe about using reversible encryption. Encryption adds a layer of security making any password more secure. Of course, the passwords should be strong ones in the first place.