Yes, it would be necessary to have a USB drive to run on that, but even with the cost of a USB flash drive included, it is the cheapest low-power device suitable for networking applications that meets the RAM requirement for pfSense. It would be nice to have pfSense working on a platform this cheap and powerful someday. :) In my tests, a device with a 400 MHz version of that type of CPU can process more traffic through it (in bridged mode; haven't tested any routing) than an Alix when running the same OpenWrt revision on both (only way I could get the same thing on both).
I don't know about the overlay, but uzip could probably be used as an alternative to squashfs, from what I've heard. Of course, this probably wouldn't be applicable for pfSense, since you wouldn't be likely to have the root fs on the device's own flash memory.