A place in the last four of the event would have guaranteed Williams that spot regardless of who lifted the trophy, but Hendry will now replace him if he wins the pounds 50,000 first prize on Sunday.
"People have got to realise I've not been playing well all season, even when I won," said Williams, 24, who became UK champion last month.
"If I don't start playing better there's no way in a million years that I'll top the rankings at the end of the season. There's no doubt in my mind about that."
Williams, defeated for only the third time in his past 18 ranking event matches, then added: "That's some of the worst snooker I've ever played as a professional."
Lee commented: "It's usually very hard work playing Mark but tonight I could have fallen out of my chair at some of the pots he was missing."
Hendry continues his bid for the 33rd world ranking title of his career today against Joe Perry of Wisbech.