Authentication and Contacts are two different types of Directory Service search policies that can return different types of information for users or people. A search policy is when Directory Services looks for information. The Authentication search policy is used by Directory Services to look up user information such as passwords and home directories. It is used when logging in to the computer or when an installer applications asks for an Administrator password.
While the Contacts search policy works, you do not need to set it up in Mac OS X 10.1 because no applications use it. The purpose of the Contacts search policy is to allow applications to look up information about people other than authentication information. An example of this would be an application using a Contacts search policy to look up information from an LDAP server about a person's phone number or address.