First, no one is saying they are opening password protected MS Office files "directly", we are all using the workaround in one way or another. Some people just don't put many details in their posts so you really have to guess at what they are saying.
There are a couple ways of opening MS Office files under iOS 4.2.X, none of them are as straightforward as they used to be before Apple released 4.2 so while you are correct that its an extra step now, it is what it is till they fix it, if in fact they see it as an issue in the first place, who knows, maybe it was intentional :-0
1- I installed the MS Office app (not 360), free from the App store, that takes care of Word, PowerPoint and Excel but I do not open that app and then use it to open my file. For me, I have my files in Apple's "File" folder app which comes standard in iOS, all the files are there in one nice tidy place. I open the file I want from within the Files app and let the phone do the rest. It looks at the file extension then looks at the apps on my phone, it finds the MS Office app and automatically opens that to open my Excel file thereby prompting me for the password. Works great and since its opening it in the proper app instead of an Apple Preview, I get to use the app features if I want. I'm actually starting to like it better than the way it was but would still like to see Apple put things back to the way they were.
2- Others just open their MS Office app first or if they don't have that app but only have the separate Excel or Word, etc app, they open that first, navigate to the file they want and open it by entering their password just like you would on a desktop.
In other words, you now need to have the app responsible for the file extension you want to open, on your device whereas before, Apple's embedded Preview opened it. What was nice about using Preview was that you could "preview' the file directly from within Apple Mail and of course now you cannot.
Hope this helps.. ..