The preseed is packed into the initrd by utah.  For d-i images, putting
preseed.cfg at the root of the initrd seems to do the trick.  For
casper/ubiquity, we use a casper-bottom script to copy preseed.cfg into
the root of the live filesystem before pivoting into it.  I can get you
more details if necessary, but as Martin indicated, we've been using
this technique for a while now without issue.  Additionally, I'm using a
preseed with a slightly stronger password that's still having the
problem, if that makes a difference.

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https://bugs.launchpad.net/bugs/1157065

Title:
  preseed install fails with "The username you entered (root) is
  reserved.."

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