Do I need the special rotary encoder or will an I-pac or similar keyboard encoder work?
An IPac won't work for the rotary part.
The rotary joystick has a 12-position switch (lower left) with a wiper arm (center top) like this one from an LS-30 (Ikari Warriors) rotary switch.
One of the outputs is always grounded ("pressed"), but you only want a keystroke sent when you turn the handle to the right or left.

Here's the basic theory of operation for the KADE and GP-Wiz40 encoders that use 3 inputs plus ground for rotary control. (From the KADE Forums thread
here)
The 13 pin connector has 12 directions + ground.
Connect every third directional connection together and you're good-to-go -- 1(1), 2(2), 3(3), 4(1), 5(2), 6(3), 7(1), 8(2), 9(3), 10(1), 11(2), 12(3) + ground.
Only requires three inputs, output keystrokes on transitions.
Input 1->2, 2->3, or 3->1 = right turn.
Input 3->2, 2->1, or 1->3 = left turn.
Of the five encoders listed on lthe wiki page, only the GP-Wiz40, KADE, and Ultimarc rotary are commonly used. (Druin isn't making his anymore and the Hagstrom looks like an expensive "translator"

)
The Ultimarc is plug and play, but only handles the rotary function -- you'll need another encoder for the buttons/joystick directions.

The GP-Wiz40 is a gamepad-style encoder that handles the rotary and the buttons/joystick directions.
The KADE rotary firmware is a keyboard-style encoder that handles the rotary and the buttons/joystick directions.
Since you're planning on using Visual Pinball, I recommend using the KADE since VP was originally designed to be played using a keyboard and almost all VP/FP tables are designed to work with the default keystrokes without any modifications/script edits.
Forgive the dumb question...What exactly is 'hysteresis'? And you're basically saying go with leafspring type pushbuttons for the flippers?
Sorry for the undefined technical jargon.
Here is a pic that illustrates hysteresis as it relates to button presses.

I recommend using either Ultimarc Goldleaf or GGG Class-X with True-Leaf Pro over
any microswitch button for flippers.
So you're saying only need 1 pushbutton on each side (for flippers)? What about tilt, etc..?
Depends on what you want.
1 button each side (1 flipper) -- Covers most tables (~95%), but does not allow nudging.
2 buttons each side (1 flipper, 1 nudge) -- Covers most tables, allows nudging.
3 buttons each side (2 flippers, 1 nudge) -- The second flipper button adds support for the tables that use Upper Flippers or MagnaSave -- maybe 5% of all tables including titles like Family Guy, Black Knight, Nip-It (seen on Happy Days), and Defender.
This does not include the ball launch button and up nudge on the front.
Scott