I don't have Office on this Win 7 rig I am using so I booted up my XP system which has Office/Word 2002.
I've tried this. I created a hyperlink, (Insert > Hyperlink), into a document for;
file:///C:\Documents and Settngs\Mark Flaxman\Desktop
When I clicked it, (CTRL+Click), my Windows Explorer opened to my Desktop folder. I never knew it could do that! 
But, I also tried a %userprofile% link and the link I used was;
file:///C:\Documents and Settings\Mark Flaxman\%userprofile%\My Documents
However that failed with the same error message you see, but I think I see the problem. Hovering over the link, Word gives me the actual link it has added, and this is;
file:///C:\Documents and Settings\Mark Flaxman\%25userprofile25%\My Documents
Notice the 25's in the link as in %25userprofile25%?
I don't understand that. I would have had theories, but they fail. In case they might help you though, I state them below;
1] The % is a non-standard ASCII character for HTML hyperlinking, and is a special character which needs defining in the hyperlink. For example, adding a space in a hyperlink I would need & nbsp : (I have had to add my own spaces in-between the & nbsp ; ). For an & I would add & amp ;
But that theory fails because in the link above, the 25 is both before and after the % and that is not logical.
2] In any case, there are already spaces in "Mark Flaxman" and "My Documents" but I see no & nbsp ; for those.
So I am stumped. I've tried Google for USERPROFILE in Word 2007 Hyperlink. I can only see one link which appears to say it is "Solved", but this is for the ExpertsExchange forum and they no longer allow casual visitors to see the solutions. You have to sign up to see the solution. Here's the link anyway in case you want to sign up and see it;
http://www.experts-exchange.com/Software/Office_Productivity/Office_Suites/MS_Office/Word/Q_26816686.html
Hopefully others here will have a better idea.
Mark