(1) use LOD meshes, Even though Blitz doesn't have this functionality (probably because it's too difficult to automatically reduce a user's complex mesh), you can create the reduced meshes yourself. You then SHOW the approprate one depending on distance from camera. Far off figures can be replaced by sprites or even textured blocks, it's too far to see any detail anyway.
Yes - this the way to do it. Terrains CAN be automatically LODded because they are derived from HEIGHTMAPS, so it's relatively easy/fast to calculate new mesh... other meshes are different story altogether. Reducing polys from say, character mesh, is VERY difficult to do automatically, and reducing polygons also affects lighting and mapping (because they are vertex based) and of course animations... so it almost impossible to do on-the-fly. And hard even if do it "by hand".